What to look for in passive parents.
At our eighth annual Morningstar ETF Conference in September, we previewed the findings of a forthcoming research paper that examines stewardship practices among the largest sponsors of index mutual funds and index-tracking exchange-traded funds. This research assesses the degree to which these funds' sponsors have aligned their own economic interests with their shareholders'. The full study can be found in the Research Library on Morningstar's corporate website.
It is perhaps more intuitive that investors in actively managed funds should consider stewardship when selecting funds, but strong stewardship is every bit as relevant for investors in passively managed funds. We found that firms that align their interests with those of fundholders by charging low fund fees, sharing a greater portion of revenues derived from securities lending, taking a disciplined approach to product development, and investing in portfolio management infrastructure have delivered above-average peer-relative performance.
In conducting this analysis, we used data from Morningstar's U.S. database of open-end mutual funds and ETFs. To supplement the data, we surveyed 10 firms that have been assigned Parent Pillar ratings and ranked among the largest providers of passively managed mutual funds and ETFs as of March 2017. These firms are presented in Exhibit 1. We will subsequently refer to this group as the "surveyed firms."
A Concentrated Industry
As Exhibit 1 shows, the ranks of sponsors of passively managed funds are dominated by the surveyed firms. This measure includes assets in U.S.-domiciled index mutual funds and ETFs, as well as assets managed by Dimensional Fund Advisors. While DFA's funds don't track indexes, the firm takes a systematic approach to security selection and portfolio construction, and Morningstar has long classified them as "passive" for purposes of monitoring asset flows. As of December 2016, the surveyed firms represented nearly $5 trillion in assets and more than 90% of U.S. passive fund assets.
This degree of concentration among sponsors of passively managed funds is not a recent phenomenon. The top firms' share has held steady for years as they've continued to pick up a majority of new flows into passive funds. Solid organic growth and market dominance are unquestionably positive from these fund sponsors' point of view, but not all of them have passed along economies of scale to fund investors. Understanding the differences between these firms' ownership structures provides context to better understand their business decisions that in turn reflect on their stewardship.
Differing ownership structures result in different sets of stakeholders and in turn shape asset managers' product development and pricing decisions, which reflect directly on these firms' stewardship. For example, Vanguard is mutually owned by its fund shareholders and runs its funds at cost, so it ultimately passes economies of scale on to its fundholders in the form of lower fees. TIAA is a nonprofit organization, originally established to offer retirement products for teachers and nonprofit workers. DFA, Fidelity, and Van Eck are privately owned. BlackRock BLK, State Street STT, Charles Schwab SCHW, PowerShares' parent company Invesco IVZ, and WisdomTree WETF comprise the publicly traded surveyed firms. Publicly traded firms must balance the interests of their equity shareholders and fund shareholders. Stock owners seek to increase the firm's share price, while fundholders want to keep their costs under wraps.
Public ownership does not preclude a firm from achieving alignment with their funds' shareholders. For instance, Schwab has tactfully balanced competing stakeholders' financial interests. Schwab overhauled its fund lineup in 2009 to offer mostly broadly diversified portfolio building-block funds and has aggressively cut its funds' fees and investment minimums. Schwab can offset lower fund fee revenue through net interest revenue and its advisory services and brokerage sales. This satisfies equity shareholders while fund investors gain greater access to inexpensive, broadly diversified funds. Similarly, privately owned Fidelity offers cheap core building-block funds that should serve investors well.