Live! Transcript 4.05.18

April 05, 2018

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

Dave Nadig: Hey folks, welcome back to Live, the most carpal-tunnel-inducing 30 minutes of my week! Let's jump right into the questions.

Bill Donahue: Dave, there are many reasons why ETFs have not penetrated the Defined Contribution (DC) market (e.g., back-office recordkeeping limitations, tax efficiency, doesn't matter; there are cheaper mutual fund share classes). How do you see this playing out in the next few years, particularly given the unwinding of the DOL Fiduciary Rule and the SEC likely to issue a draft fiduciary rule sometime during fall 2018? Do you foresee some ETF sponsors working with recordkeepers to develop a recordkeeping solution for DC plans?
Dave Nadig: Awesome question. I will admit I've gone back and forth on how important the 401(k) market will be to ETFs for about two decades now.
The real issue is that ETFs have grown largely on the back of a few features: Transparency, Intraday Liquidity, Cost Efficiency and Tax Efficiency.
Two of these are completely irrelevant in the DC market: taxes and intraday trading.
Cost: most big DC plans have some very very-low-cost index funds already, and the cost issue can actually work AGAINST ETFs. Many plans are funded by 12b-1 fees from their actively managed mutual funds.
So an "all-ETF" plan would need to charge separately for recordkeeping.
And that really leaves transparency. And while I think that's important, I don't think it's overwhelmed the "who pays for the plan" problem. A vigorous fiduciary rule--particularly one that was baked into ERISA--could force an unbundling of fees, and that would be good for ETFs--but also for index mutual funds.
So, overall, I'm a bit lukewarm on whether we'll see a LOT of growth and activity there.
(That said, Schwab did some very interesting work in the space a few years ago. I just don't think its had a ton of traction selling it.)


JRutsey: Do ETFs even work for fixed income? Wouldn't active security selection of bonds be better than a passive, market-weighted index?
Dave Nadig: Traditional bond indexes don't really make a lot of intuitive sense.
They give the most money to the companies or countries that issue the most debt--which generally skews risk. It's not how most people personally would decide who to loan money to.
So, intuitively, you're right. And given the enormous ineffeciency in the non-Treasury bond markets, you'd think that crafty players would have an edge regardless.
But statistically, the average active bond manager still underperforms even the "dumb" benchmarks. So it's a bit like the old saying about democracy: it's the worst system, except for all the other options.
I'm genuinely surprised we haven't seen more true "smart beta" fixed-income index ETFs take off, honestly. There has been some good work done there, and a few funds that take advantage of some inefficiencies baked into the system--Van Eck's Fallen Angels ETF for instance (ANGL) ...
And Deutsche has an emerging market smart-beta bond strategy I think is pretty clever.
But in general, the average active manager still struggles, even in bonds.


GLW: What's the one overlooked ETF (or type of ETF) you think should be in everybody's portfolio?
Dave Nadig: Right now, commodities.
I think a lot of people have approached commodities as just a flier in their portfolios. They buy oil when they think it's going up, etc.
But I think for most investors, a long-term, rebalanced position in a broad, cheap, non-K1 basket of commodities makes a lot of sense.


Robert Baird: What did you think of the failed merger between Turner Investments and Elkhorn?
Dave Nadig: Kind of a breaking news question ... I don't have any inside baseball or gossip here, but in short, it looks like a bunch of the Elkhorn funds will be shutting down, and at least one will be taken over by Innovator Funds.
But here's the point I'd make: Here we have what is in some ways the "worst case scenario" for a small ETF startup--but still, investors are basically going to be just fine.
Either the fund they're in will be liquidated at NAV--which is really just, worst case, a tax event they might not have wanted.
Or it gets taken over, because there's an independant board that reassigns the management.
It's really kind of beautiful--it all just works like it's supposed to, even when things go really wrong (from Elkhorn's perspective).


Ed: We have been seeing a slowdown in overall ETF inflows? Was last year a fluke for new assets? What's going on, in your opinion?
Dave Nadig: Hey Ed, in general, I always expect flows to follow performance. They SHOULDN'T--but we all know that, as a class, investors chase performance.
So when you have a bad month, investors sell. Or put another way--things go down BECAUSE people sell.
So I actually would have been shocked to see the markets sell off and there be a ton of inflows.
I think the real story of the first-quarter flows though is international equity
If you look there at the asset class table, $40B in flows into international to me says investors are making a bet not against risk, but against the U.S. I think that's super interesting.
If we have a long-term sustained equity market decline, I would suspect flows to be a bit anemic. We saw that the last time as well.
Again, a bit of a question of, which is the tail, and which is the dog, but they're just always going to be related.
And equity is still 2/3 of ETF assets.


Chris Damon: Anything from the Awards surprise you?
Dave Nadig: I was a little surprised at the winner of ETF of the Year, which was the Ark Inovation ETF.
Surprised because it's a few years old, it's not enormous ($660 million), and it's actively managed.
Now there's a pretty good reason why--it's up 66% over the last year!
So, clearly, the folks voting think that having that kind of performance validation of an active strategy is worth singling out.
FWIW, I think it's an interesting take on a tech fund, because it really fishes from a lot of ponds: Tesla, Twitter, biotech, etc.


Marty C: How meaningful are the MSCI ESG scores in your fund pages? How can a fund like CXSE and MCHI have almost identical ESG scores?
Dave Nadig: Well, "meaningful" is relative. I was actually just on a panel today with Linda Zhang from Purview who made an interesting case
that we're used to thinking about a two-dimensional frontier: risk/return, and that we're headed toward a 3D, surface-based frontier, where the third dimension is some measurement of impact, or "ESGness."
It's obviously a pretty individual point of view, but the evidence is mounting that there are real risk/return benefits to considering the ESG side of things as well.
As for how you can end up with funds so close, the MSCI overall score takes into account a huge number of factors, so you can get a "good" score in a lot of ways (or a bad one).
But seeing two China ETFs have similar scores isn't hugely surprising, even though they have such different approaches.
In the MSCI methodology, governance and regulatory environmental issues can push things a lot, which is why you see so many EU country funds (like Sweden, Portugal) WAY at the top of the rankings.
So it's worth looking at all the different angles on that ESG tab in the screener to try and tease out a bit of the "why."


Ben: Would it make sense for a large active mgr (TROW, BEN) to acquire an ETF firm?
Dave Nadig: Well, yes and no. We've seen plenty of these kinds of acquisitions already, Oppenheimer buying RevenueShares, etc.
But in some sense, if you're big enough (Fidelity), you can afford to just go it alone.
An acquisition probably makes the most sense for a midtier traditional manager, because they can benefit from the jumpstart on both the intellectual capital side and the infrastructure side.


Dan: What do you make of these AI-powered ETFs popping up?
Dave Nadig: Seems like a pretty logical progression from smart beta, honestly. If the "dumbest" smart beta is just identifying a factor, then it strikes me that the "smartest" smart beta is just algos that reinvent factor investing in real time, and that's basically what many of these approaches are doing.
I think calling them "AI" is a bit of a gimmick--they're really just a different approach to quantitative investing. I think it's cool that some of them use things like text-processing to read headlines and all that jazz.
But hedge funds have been poking at that bear for a decade--some successfully, some not.
So I think it's fun, but I'm always skeptical.


Michael T. Kennedy: How is First Trust so good at distribution? You rarely see their name or logo anywhere, but they keep killing it with flows...
Dave Nadig: Well, while they may not be a household name to everyone, they're hardly an unknown. They've been managing money for about 25 years, and actually launched a TON of products along the way.
Having a very large product line means, among other things, that SOMETHING is always performing well.
Combine that with a really traditional, shoe-leather strategy (folks pounding the pavement, taking meetings, talking strategies, day after day) and it's worked for them.
In other words: performance plus hand-to-hand combat is a good combination, in almost any market.
I don't think it's much more complicated than that. It helps that they have some wicked-smart people on staff that write well, and have developed a following from an economics perspective.
That gives advisors a reason to take the meetings.


Iphegenia Doubtfire: Is there a way for investors to play the trade war with ETFs?
Dave Nadig: I'm always a bit skeptical of "Can I play X with an ETF" questions.
The short answer is "of course" ... it just depends on how active you want to be.
You COULD, for instance, short soybeans (SOYB) and go long U.S. materials companies or something, but I always worry that by the time the average investor is researching the ETFs for a given premise like this, much of the price is probably baked in.
There are hedge funds out there jumping on EVERY headline, and that's part of why we see the kind of swings we've been seeing in the market in reaction to every bit of political posturing.
It strikes me as a pretty dangerous game to play--thinking as an investor you can be smarter than the market pricing that stuff in moment by moment.


MaryJane: Canada has been leading the charge with the cannabis industry. Do you see the US and specifically US ETFs catching up?
Dave Nadig: Clever name, MaryJane (grin).
Actually it's not just cannabis--I see Canada as a leading indicator on how things happen in U.S. financial services in a lot of areas. I mean, Vanguard "tested" its smart-beta funds in Canada before it launched them here, and so on.
Do I see a pure-play U.S. cannabis ETF catching on (other than the one we have)? It seems SUPER niche to me. That doesn't mean it can't get some traction.
After all, we have lots of thematic ETFs that get their moments in the sun, like HACK.
But I could argue that, at what, $300 million or so, MJ is already having that moment in the sun. Hard to see how you have 2-3 competitors show up until it becomes much more mainstream, and that will require some regulatory shifts in the U.S., I think.
OK, last question and then we'll wrap until next week.


Ben: What is the future for smaller ETF mgrs (non-Vanguard, BlackRock, StateStreet). Will they be able to grow organically, or is the ETF space forever a three-horse town?
Dave Nadig: It's worth noting that a "small issuer"--a non-"top three" like a WisdomTree or a Van Eck, is huge compared to how we thought about ETF companies a decade ago.
But that said, the reality is that for the segment of the market focused on cost, there are real, difficult-to-compete-against economies of scale.
I can't imagine a startup ETF launching a 4 basis point large-cap equity ETF and geting traction. I just don't see it.
Where smaller players really can differentiate is in the non-vanilla space, and we're seeing that in spades. Just from this chat--ARKK, CXSE, ANGL--three super innovative funds, with real money, real traction, and not a lot of competition.
Of course, if something like CXSE becomes a $10 billion, staple investment for institutions, you'd see copycat strategies, but the first-mover advantage tends to stick, even for smaller funds.
So while I think there's a natural asset-level dominance at the top of the food chain, I think there's tremendous opportunity for smaller firms.

Have a great afternoon everyone.

Find your next ETF