Bernstein: ETF Fee War Fuels Competition
November 13, 2012
The fee war everybody is talking about in the world of ETFs these days between Schwab, iShares and Vanguard is certainly good for competition, money manager and former neurologist Bill Bernstein says. But Bernstein, author of fun and readable books such as “The Investor’s Manifesto,” also argued that the price differences in question—sometimes just a few basis points—are hardly worth getting excited about.
When IndexUniverse.com Managing Editor Olly Ludwig caught up with Bernstein recently, they talked about everything from the validity of enhanced indexing methodologies to the possibility that the popularity of products such as dividend-rich ETFs could cause correlations to rise at exactly the wrong time.
Ludwig: There's been a lot of change in the world of indexing recently. Many people call it a fee war between Schwab, Vanguard and iShares. Do you have some general observations about this?
Bernstein: It’s much to do about nothing.
Ludwig: When you say that, are you talking about the expense ratio? Are you talking about the different indexing methodologies?
Bernstein: All of the above. There are a few big mistakes you can make in indexing, and they’re not even big mistakes. They're just mistakes that will cost you a dozen basis points a year: investing, for example, in the S&P 500 Index vs. some other large-cap index. And the reason is, because everybody in the world indexes the S&P 500, and when it reconstitutes, you're going to incur some transactional costs following that reconstitution. Everybody is trying to get in and out of the same little narrow door at the same time.
Ludwig: So all this hoopla about Schwab bragging about what they’re doing is just drops in the bucket? On the emerging markets funds, for example—we’re talking about a 5 basis point difference a year, 15 for Schwab, 20 for Vanguard. And it’s 18 basis points for that new iShares product.
Bernstein: Yes. But the competition is obviously very healthy. Remember Vanguard’s first emerging markets index fund. I think it had a 60 basis point expense ratio. And now, it’s down to a third of that. That’s extremely healthy.
Ludwig: Yes. So, at the very least, all this maneuvering and posturing is keeping that downward pressure on funds.
Bernstein: Yes. I’ll tell you what's sort of the bigger societal issue about this that I really find absolutely fascinating. You look at Vanguard, and it’s quite obvious that it’s going to basically, in the long run, blow all of these companies out of the water. Why? Because it doesn’t have to make a profit. And because it doesn’t have to make a profit, it will continuously accumulate market share. People come to that. And so you’ve got a nonprofit, if you think about it, which is providing a financial good, which is blowing away for-profit companies.
Ludwig: So let's talk about BlackRock's iShares, which just launched this new lineup of 10 core funds. They look pretty credible. But in this competitive landscape that you describe, where Vanguard would prevail over the long haul, these 10 funds are just sitting behind a moat, sort of “deck chairs on the Titanic,” as you had once told me with regard to something else, in terms of Black Rock’s ultimate competitive challenge here against Vanguard?
Bernstein: Yes—I mean, are you ordering the sausage pizza or the pepperoni pizza? It’s usually not a difference.
In other words, if somebody told me, “You can't invest in Vanguard and DFA [Dimensional Fund Advisors] funds anymore. You can only invest in BlackRock and WisdomTree,” I would say, “All right.” I don’t think I’d be able to do quite as good a job, but it wouldn’t be the end of the world.
Ludwig: You just mentioned WisdomTree, and I'm wondering, from where you sit, what do you think of these enhanced indexing methodologies from WisdomTree or Rob Arnott that are supposed to provide a little extra return by tilting holdings toward small-cap or value stocks? Are you buying it? Or are you pretty skeptical?
Bernstein: Rob Arnott is probably doing about the same thing that DFA is doing. But it’s just in a slightly different wrapper. It’s a different way of packaging the value effect.
And yet, you talk to one side over the other, and it’s like you're dealing with the devil! It’s very ideological. Do I come down on one side or the other? No. I think they're both doing pretty much the same thing.
Ludwig: So you wouldn’t take issue with the very premise of what Arnott is up to, for example?
Bernstein: No. If somebody told me I couldn’t invest with DFA, I could only invest with Rob Arnott, I’d say, “OK, I’ll do that.”
Ludwig: Are there aspects of the current investment landscape that give you pause and make you think that in the coming years things ought to be slightly different?
Bernstein: Yes. I’m slowly coming to the realization that there is way too much money chasing alternative investments. When there's too much money chasing stocks and bonds, that’s a bad thing. It lowers the returns. But that pool of investments, that pool of opportunity is so large, that you can't completely screw it up.
Whereas, what you have now is you have this enormous pool of capital. You're talking about half of the university endowments; you're talking about a large chunk of pension funds. You're talking about anybody who walks into a wealth management department. And you're talking about a very large chunk of the portfolio being invested in four asset classes: hedge funds—if I can consider that an asset class; commodities; private real estate; and private equity.
And those four opportunity sets are much smaller than the ones we have been talking about. It’s not that much alpha there. There may not even be that much expected return there. And people are buying those things for all the wrong reasons. They're buying them because of their past low correlations.
But as we saw in 2008 and 2009, that’s all gone. And I even have a pretty good idea why those correlations are rising very dramatically. It’s because, who was investing in commodities back in the 1980s? Well, David Swenson was! He had the playground to himself. He was one of the first people who realized that commodities were a good idea. And he couldn’t buy the Oppenheimer fund. He couldn’t buy the Pimco fund, because those didn’t exist. He had to go out and actually get managers to get into the pits and jostle with a bunch of ex-linebackers, all braying for money, and take the long side of these contracts where the major players were the producers.
He did something that was very difficult to do. And he got excess returns. And the correlations were low because no one else owned these things.
Ludwig: To be clear, we’re talking about futures-based vehicles?
Bernstein: Yes. And now who invests in them? Well, now, everybody and their dog own the Pimco commodity fund. And during the next crisis, they're going to hit the sell button for that within the same microsecond that they hit the sell button for their stock and bond and real estate funds, too. So the correlations will go to 1. The correlations are already dramatically increased. But those correlations will not be -0.2 or -0.4. They’ll be 1.0 during the next crisis.
And as more and more money pours into this, I see returns falling, I see correlations rising. And I see tears. And I see a lot of bad things happening for a lot of people.
Ludwig: Now, with regard to trendiness, Invesco PowerShares brought to market an ETF a couple weeks ago that combines high-dividend screening with low-volatility screening. That’s exquisitely calibrated marketing, combining two of the hottest trends of the past year or so! I'm wondering if you might opine about the dividend craze, as people worry that bond yields are really giving paltry income, and so they're looking elsewhere. And what about the whole low-volatility fund trend as well?
Bernstein: Again, too much money chasing too little opportunity. Let’s assume that there is an anomaly there. And let’s assume that there is $1 billion of alpha in that anomaly. So let’s say you think you’ve found an anomaly, and there's $1 billion of alpha. And let’s say that you're starting a hedge fund that’s going to do that, and it’s going to chase that alpha. And you’ve got $10 million of transactional costs. Well, you’re going to make a lot of money. You're going to spend $10 million in transactional costs. But you’ve got this whole pool of $1 billion that you're going to get a large chunk of. So you're going to do fine.
Now, when you’ve got 50 funds chasing it, now you’ve got $500 million of expenses chasing $1 billion of alpha. So your take dramatically increases. At 100 funds, your alpha all disappears. And when there's 400 funds chasing it, and now everybody on average will earn a big negative alpha, that’s the phase we’re at with low volatility, I think. You’ve got everybody and their dog chasing this.
Ludwig: And what about high-dividend securities?
Bernstein: Same thing. What happens when you’ve got 400 funds chasing that opportunity? And when you have a large number of funds that earn a negative alpha because their expenses exceed the gross alpha, well, three things happen. The first thing that happens is that the correlations will rise, because you’ve got a bunch of unsophisticated shareholders who are willing to sell at the first hint of trouble.
And then the second thing that happens in all these funds is the returns fall. And so the questions you always have to ask yourself, when you're thinking about an approach are, Who are my fellow shareholders? How strong are their hands?
And if the answer is, you’ve got an asset class that is out of favor that is being bought by value-driven people; the correlations will be low because those people will have strong hands. You're not going to sell when everybody else sells.
But when you’ve got a bunch of people chasing high-yield stocks because they can't stand T-bills and CDs, then your fellow investors have weak hands. And that’s bad.