Live! Transcript 3.8.18

March 08, 2018

[Editor's note: Live! with Managing Director Dave Nadig happens Thursdays at 11:30 a.m. ET, with the question window available two hours before and during.]

Dave Nadig: Good morning folks, Dave here.  Welcome to the first run at a new feature for us, a live Q&A.
There are no stupid questions—or if there are, I've probably already asked a lifetime's worth. So let's get started.


Bill Donahue: Eric Balchunas shared a chart on Twitter showing that 1/2 of the top 30 asset managers do not currently have ETFs. How do you expect this landscape will evolve over the next two years?
Dave Nadig: It seems like just a few years ago we were talking about how the industry was too concentrated in the first movers, and it was impossible for anyone to make any headway.
But honestly, I look at the league tables, and I see a lot of movement.
I was at the launch event for Schwab's ETFs like, maybe 7-8 years ago, and a lot of us in the room were thinking "good luck trying to out-Vanguard Vanguard" and here they are, knocking at 4th place.
Northern Trust - a bit out of nowhere, now a powerhouse.  Fidelity, now a 10B complex, with just a few funds.
So I think there's a lot of room still, with the big caveat that distribution is incredibly important.
If you look at who's been successful in the last few years, it's folks who bring some distribution to the table -- or who get very, very lucky with a niche, thematic product (HACK, for example).
But I think Non-Transparent Active funds become a thing, and then it's a bit Katy Bar The Door -- we'll see a lot of products launch.  Whether the assets flow?  Well, we'll see.


Joel Miller: They were talking about new fund RVRS on Bloomberg yesterday. Would you buy that one or just RSP?
Dave Nadig: Hi Joel.  So RVRS -- that's the Reverse S&P 500 Fund.  It basically weights the S&P backwards.
Theoretically, if you take SPY and RVRS and you own them equally, you're "sort of" making RSP. RVRS is just a much more extreme version of overweighting the midcaps.
I think it's an "interesting" product.  It's a bit of a scalpel for reweighting your large cap -- or really megacap -- exposure if you're an S&P 500 investor.
So I think it's a pretty narrow, fine-tuning use case.  Honestly, you can say that for a lot of funds launched in the last few years: narrow, fine-tuning use cases.


Mike Shell: Do you see selecting ETFs any different than choosing between active funds? Even in the same sector or classification, index ETFs can have unique return streams, so the dispersion can be material.
Dave Nadig: Hi Mike -- boy I think there's a WORLD of difference.
Selecting active managers is, to me, a bit of voodoo.  You're making a direct assessment of a human being, or a team of human beings, and the processes surrounding them.
Picking a passive (indexed, or smart beta) ETF is really just about understanding your exposures.  But those exposures are a LOT more predictable.
There's essentially zero chance that your index-based emerging markets fund all of a sudden starts buying UK manufacturers, for instance, or decides to hold 20% cash for a while.
That said, I actually worry some ETF investors DONT look enough at exposures.  As you point out, the difference between funds that look very headline similar can be HUGE.
it all comes down to looking under the hood at the index itself, and how it's constructed.


Stephen: Are there trading halts based on the deviation between the ETF market price and its indicative value?
Dave Nadig: At the moment, I'm unaware of "any" formal system that looks at the iNav or IOPV or IV (all acronyms for intraday fair value assessments) and relate that back into the exchanges themselves.
If you think about it, it would be blisteringly difficult to do.  How would you handle foreign securities, non-trading bonds, commodities that close before 4PM, and so on.
These are all issues that drive day-to-day prices to differ from iNAV very naturally, so building halts off them would be super problematic.
In the wake of August 24 some years ago, the exchanges did fine-tune a lot of the plumbing around circuit breakers and reopens from halts and so on, and so far, my assessment is it's worked quite well.


Tim D: Why is there not level a playing for exemptive relief regarding custom baskets as it relates to creating/redeeming in FI ETFs?
Dave Nadig: Now THAT'S a big hair question (grin).
So, ETFs are super unique, among financial products, in that they essentially exist by loophole and exemption.  Everything cool about ETFs comes about because they break the rules -- legally.
So the first firms out of the gate -- State Street and now-Blackrock (then Wells Fargo Nikko Investment Advisors) -- got very different rulings on how and what rules they could bend than someone going in today would get.
This tends to come up around creation/redemption.  Early entrants often have huge flexibility.  They can, for instance, have ZYX in the creation basket, but put XYZ in the redemption basket, essentially allowing creation/redemption activity "make trades" for them.
They can even negotiate a basket for a big trade.
So it's mostly a historical accident, but a very meaningful one.  Every year or so, regulators talk about an "ETF Rule" that would clean all this up.  But it's perpetually about a year out, so I'm no longer holding my breath.
I do think it's needed, however.  Level playing fields are, long term, good for everyone, including investors!


Guest: Why are closed-end funds not considered ETPs?
Dave Nadig: So, CEFs are, generally speaking, also registered under the 1940 act (like mutual funds and most ETFs).  So they live by "some" of the same rules as both ETFs and mutual funds.
The HUGE difference is that a CEF, while you do buy and sell it on an exchange, like a stock or an ETF, doesn't have a continuous creation/redemption process.
Most CEFs issue a set number of shares, and that's mostly it.  They have various liquidity periods and lockups and conditions for issuing new shares and so on, but not a daily process like ETFs.
That continuous process is what allows ETFs to trade very close to fair value, and the lack of it is what forces many CEFs to trade at wide discounts or premiums to their fair value.  Their trading price is at the whim of investor supply and demand.


Matt Hougan: Five years from now, will the largest S&P 500 ETFs exclude any of the following securities: a) Companies that manufacture firearms; b) Companies that have clear failures on equal pay; c) Companies that don't offer appropriate voting rights for shareholders?
Dave Nadig: Matt Hougan - slumming it from the Bitcoin mines I see.   But seriously ...
I don't think you see the S&P 500 change its rules.  I really don't.
Because the index you'rr talking about basically exists.  It's the SPXESRP (I was looking at it earlier for an article).
its the S&P500, minus all the sin stocks and gun companies and heavy polutors and so on.
It culls down to something like 350 stocks.
So what I "do" think you'll see, slowly, is institutional mandates migrating toward products like that.  It will be slow, but I do think it will happen.
(Worth noting, I don't think the S&P 500 has any gun stocks, as they are all small caps.)


Anonymous: Can you ever close an ETF to new investors, like with a mf, when it gets too big to efficiently scale?
Dave Nadig: Short answer: No.  Longer answer: Sort of.
So, TECHNICALLY, a fund can "close the window" for new creations.  And we have seen it from time to time.
It generally only happens when either the issuer forgot to file some paperwork (happened in some USCF funds a while back if I recall, for like, a day), or when there's some sort of structural problem.
An example of the latter would be when EGPT closed for new money during the 25-ish day closure of the Egyptian markets during the Arab Spring.
What happens then is predictable -- the ETF trades out of whack to fair value -- in that case, to monster premium.  When it reoppened, it came way back down to fair value.
But from a practical perspective, no, ETFs are designed to be continuously open so they will trade around fair value.  If an issuer's strategy can't handle size, generally it shouldn't be in an ETF.


Sam: Are all gold ETFs taxed as collectibles?
Dave Nadig: Nice and simple one!!!  Most.
GLD/IAU and so on, which old physical gold in vaults, get taxed as collectibles.
The ones that hold futures (DGL I believe) are taxed as commodities pool (60/40 long/short marked to market each year).
And of course, miners (GDX/GDXJ for instance) are just equity funds.


Sam: Can exchange trading halts cause ETFs to deviate from their NAV?
Dave Nadig: (I'm sort of bouncing around questions, ill try and get to all of them here if I can)...  But on Sam's here:
So when an ETF halts trading, generally whatever it owns doesn't also get halted.  So for example, if a small cap tech ETF halts for some reason, let's assume the 100 small cap tech stocks it owns keep trading.
Sort of by definition, the fair value will continue to move, while the ETF doesn't.  All else being equal, when that ETF reopens, it will price pretty close to fair value.
Now, if there's some sort of huge market disruption -- all the small cap tech stocks gapped down 20% on the open or something -- then all bets are off.
In those cases, we've historically seen a back and forth of pricing information, where as stocks reopen, the ETFs reprice, and vice versa.
But fingers crossed, we haven't seen that kind of event in quite some time now.


David: Are there any hidden risks to ETFs and how they are built? Can a broad-based ETF based on the S&P 500 reduce more than market beta in a downturn? What's the best way to "look under the hood"?
Dave Nadig: In general, ETFs are a pretty straightforward wrapper.
The vast majority are just '40 act mutual funds under the hood, with boards that are looking after the interests of investors, and so on.
That said, I think where investors can get in trouble are in a few places.
They're traded vehicles.  Because they are traded, disruptions in the trading markets can impact them on a short term basis.
So can an S&P ETF get pushed off its fair value -- yes, for a short period of time, or with a low volume.  But assuming otherwise functioning markets, it's too easy for Authorized Participants to make "free money" arbitraging out price differences for anything like that to persist.
Now if it's a tiny ETF, with no trading interest, etc., then you can see a small trade on the tape be out of whack -- but that's why you as an investor need to just use some basic trading common sense.  No limit orders.
They're just exposures.  You "have" to know what you own and why you own it, just like you would with anything else.  Don't believe headlines.
Under the hood?  Dare I say read prospectuses?  Or you can find info here ( or whatever ticker).  You can find holdings and portfolio info there as well


ClockworkAngelInvestor: With most big trading platforms restricting which ETFs they list based on size, liquidity, longevity, etc., do small/new ETFs even have a chance to get big any longer? Or does the infrastructure of trading itself prevent all but the luckiest or hottest-trend funds from getting in front of investors?
Dave Nadig: If you're a little guy with an idea, I'll be honest, it's a TOUGH market.
I don't think that's a new thing however.  It's always been tough for small investment managers to move the needle on distribution.
Many if not most major platforms will have some process for limiting the list of ETFs available to their investors -- that can be a retail shop having a blanket rule against, say, all leveraged funds or all ETNs, or it can be an advisor platform limiting their advisors to a small "approved list."
There's no secret sauce, but demand generation is the name of the game.  I remember when "HACK" caught fire.  It was NOT on many platforms, but there was enough advisor demand (calls back to home office) that I know it got on at least a few platforms in an expedited fashion.
But there's no secret sauce. It's about shoe leather and good ideas.
I've been asked a lot if this is "fair" and I guess my response is: what business is?  How easy is it to launch a new desktop operating system?  Or airline?
It's a BIG business with entrenched players.  Disruption is "hard."


Mike Shell: I promise that my original question asking if you think selecting an index ETF is any different than selecting active funds is any different. You made a great point that I very much concur with that it’s essential to look at the exposures. But then, when you say:

“Selecting active managers is, to me, a bit of voodoo.  You're making a direct assessment of a human being, or a team of human beings, and the processes surrounding them.”

It brings up another observation - so are indexes. An index is a black box and many are also operated by “a human being, or a team of human beings”. We don’t know in advance which stocks they’ll add or delete and the index weighting changes over time as well. So, we can know what the exposures are until the next reconstitution, but then it changes.
Dave Nadig: Good follow-up here, I'll focus on the observation, and disagree a bit.
MOST indexes have a rulebook, and that rulebook tells us what the index WILL do.
This is why, for instance, the Russell rebalance is pretty predictable.  We can all read the rules, and know with pretty near certainty which stocks will go in and out.
There are exceptions, particularly in old-school indexes.  The S&P 500 and the Dow, for instance, are not nearly as formulaic as, say, the MSCI US Large Cap index.
Even if you get into the smarty-pants smart beta stuff, most of them have pretty easy-to-understand rulesets.
I would argue if they DON'T, if they're littered with committees and overrides, well, then you should be skeptical, and start looking at them like active funds, where the people and processes are of primary importance.
But, U.S. Min Vol?  I can predict preeeeety clearly what's going in and out at each rebalance.


DMV: Why are ETFs not used in 401(k) accounts if they are better than mutual funds?
Dave Nadig: So, super nerdy answer.
If you're sticking $500 into your 401(k), you need to divide that up across a few funds.  If an ETF can only be bought one share at a time, you're going to have a very sloppy trade.  If the ETF is $150, well, you're either putting in 150, 300 or 450 into it.
Mutual funds trade in fractional shares, so you can buy 1.0243 shares of some mutual fund.
This makes doing any kind of dollar cost averaging much much easier in a mutual fund, and that's how every 401(k) record-keeping system since the dawn of time was built.
There ARE ways around it, of course, and some folks (Invest 'n' Retire, Schwab, to name a few, have figured it out.
Usually, it involves "repooling" the ETF shares into a trust, and then doing fractional shares of the trust.
To which the logical question is, "why bother if you can just get the same exposure at the same cost in a mutual fund"
And most of the time, you can get pretty close.
The second less-nerdy answer is that many 401(k) plans use 12b-1 fees from the target mutual funds to offset record-keeping costs.
99.99% of ETFs don't charge 12b-1 fees.
Also worth noting, two of the big ETF features -- intraday trading and tax efficiency -- are generally irrelevant in 401(k)s.  So not a huge push.


Jim Wiandt: What issues in the ETF and index industry are you most concerned/excited about for 2018?
Dave Nadig: The prodigal son returns!  Hey Jim.  Great question!
So, I have been saying it for 3 years, so eventually I'll be right -- I think we'll see Non-Transparent Active finally crack here soon.  Soonish.  Soon enough.
I'm excited to see how that plays out.  On the one hand, I think a lot of the various structures are super interesting and clever, and I love clever.
And I think it could bring a whole raft of new players to the market.  All of that's exciting.
On the other hand, I'm not 100% convinced they're solving a problem investors actually have, so I'm curious to see how they do in gathering assets.
As for the index industry -- I'm watching the moves into direct indexing by folks like Personal Capital, Wealthfront and their ilk with a keen eye.
Theoretically, a real move towards direct indexing (just buying individual stocks in a pool, instead of an ETF, using tech to make it efficient) could hamper ETF growth, but at the same time, make a choice of INDEX even more important.
LOTS of things have to happen for it to move the needle, but I think it's super interesting.


ClockworkAngelInvestor: How much does a cute/clever/memorable ticker REALLY matter to the success of an ETF?
Dave Nadig: Hey, we all LOVE a cute ticker.  It's one of the reasons (ok, it's the only reason) we still have that as the last category in the Awards every year.
I would really, really like to tell you it doesn't matter at all.  However I know better.  Investors and advisors often associate a whole investment theme with a specific ticker when there's some sort of event, and boy, does that STICK.
Consider the QQQs -- back when I was running a mutual fund, the guys on my trading desk were "addicted" to trading the QQQs when they had extra cash (we were a tech fund).
It doesn't matter if there are better proxies for tech, it got a reputation as being "tech cash" and it STILL gets used that way across trading desks.  Ditto GLD, HACK, SPY and so on.
So it's not the "cute" that matters, it's the representation.
I remember when WisdomTree was putting up billboards with DXJ on them talking about "Japan without the Yen."  It was super effective, and I think it locked that investment thesis to the DXJ ticker with authority.
I think you could launch a competitor that was at zero basis points, and DXJ would STILL be the go-to ticker for that investment meme.
OK one or two more questions here ... sorry if I miss your question, but we'll be doing this every so often!


Beth: Aren't ETFs more risky?
Dave Nadig: Well, that's a big loaded question, ain't it? (grin)
I'm going to assume the implied "... than mutual funds" here.
So the short answer would be no, not if you pay attention.  If you put an S&P 500 mutual fund and ETF next to each other, the performance expectations  - both risk and rewards - will be identical.  The ETF will likely pay out less in capital gains, but assuming you were in a tax-deferred account, there's no difference -- except ... for trading
IF you go out of your way to trade the ETF poorly, yes, you are exposed to an execution risk you don't have in a mutual fund if you just put in an order and buy at the end of the day.
But there's a flip side to that -- if you put in your mutual fund order at 3PM, you have NO IDEA what price you're getting at 4PM.  So you're taking on timing risk instead of execution risk.
Personally, I like risks I can control, and execution risk is very managable: use limit orders near fair value.
OK, last question, lemme find a good one here.


ClockworkAngelInvestor: What do you think of AI-driven ETFs (like AEIQ, etc)? Is Skynet the next big thing in active management?
Dave Nadig: Skynet!  Oh lord.
I think AI systems in investing are super interesting, but I also think markets are much more complex than people realize.
There's nothing really new here -- AI is just algos by a different name.
There has for sure been a lot of progress in natural learning -- AI's can learn how to beat people at games now that they used to have to be preprogrammed for.
But all of that activity -- the buying and selling implied by USING an AI -- all becomes part of the very system it's trying to game.  It's a reflexivity issue.
So while I think it's interesting, I also believe there's some inescapable math -- security prices are always a zero-sum game.
Every buy is a sell, etc..
So will AI be better than a BAD active manager?  Sure.  But so will passive.
The question really is -- are we getting any better at culling out the bad active managers from the system?
Based on the quarterly S&P Index vs Active reports, it sure don't look like it.


OK, with that, I think we're a wrap.
We'll be shooting to do this every Thursday around 11:30, opening up for questions 2 hours ahead of time.
We'll also publish a transcript of this live chat shortly at
Thanks everyone for the fun questions, and we hope you found this a useful diversion.
(This URL should magically BECOME the transcript as well.)
If anyone wants to give me any feedback, you can reach me at [email protected], or on twitter @DaveNadig.  Have a great day folks.

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