Live Chat: Dissecting Tracking Error & 'QQQ'

May 16, 2019

[Editor's note: Join us for a weekly Live Chat! with Managing Director Dave Nadig.] 



Dave Nadig: Good afternoon folks, and welcome to Live!
As usual, you can type your questions in the box below, and I'll cram in as many as I can in the next half hour.
One quick shameless plug: We're hosting an ETF 101 webinar next week. Just us, no sponsors or anything. The idea is for it to be a real open forum where we can dive deep.
I'll do some 101 presenting in the first bit, and then it's all open Q&A. You can register here if you're interested:
OK, let's get to the questions.


Janet: Soundtrack?
Dave Nadig: Sleater-Kinney. It's been a punky week or so:

Jackson Broward: Volatility is a big issue right now in the market. Are there any ETFs specifically for that?
Dave Nadig: Hi Jackson - lots of options here.
If you are trying to bet on volatility spiking (as in, a short-term, few-day kind of event) then there are a bunch of ETFs that directly track VIX futures. The big one there is VXX.
The caveat is that it can degrade a lot over time due to the contango in the VIX futures market, so you should think about it (and the many funds similar to it) as trading vehicles, not investments.
If you are, on the other hand, looking to invest in equities but are worried about volatility, there's a raft of products designed to minimize your exposure to that volatility.
USMV and SPLV are the two biggest in the area.
But here's the big list:
They generally do what they say on the tin, but there are a lot of differences between them: You can go large cap, small cap, U.S., international, etc.


Stef: With all the unforeseen areas that FANGs have gotten into, is there any industry they won’t step in to? Insurance …?
Dave Nadig: Insurance is a good call. I do think we see them get into financial services though.
Probably banking is a first step, but they are natural distribution platforms for things like robo advice services.
And eventually, I think someone in the group steps up with a low-cost direct indexing service.


Larry: I don't understand tracking error... why does it matter?... at the end of the day we want returns in our investments ... if my ETF is up 10% or down 10%, how does that matter?
Dave Nadig: So, "tracking error" is an academic measurement of the standard deviation of daily returns between a benchmark and a portfolio. So between, say, SPY and the S&P 500.
For most ETFs, it's irrelevant. Much more important is "tracking difference."
TD is a measurement of how a fund does compared to the thing it's promising over rolling 1-year holding periods.
Your nominal expectation is that a perfect index fund trails its index by exactly its expense ratio.
But reality is messy. Funds optimize, they lend securities, and so on. They have to manage rebalances and so on.
So TD gives you a better barometer of your true cost, often, than just the expense ratio.
And it can be dramatic.
It's basically a way of deconstructing your performance.


Beyonce: I just listened to the "Trillions" episode celebrating the QQQs. I seem to recall you once called it "the worst" ... what did they miss?
Dave Nadig: Was excited to see this question! So, great podcast. One sec for the link:
They point out that the QQQs aren't really a tech fund and all that, and it's a good listen, but they missed a few key issues:
1) QQQ is ONLY NASDAQ-listed nonfinancial companies. Not the top 100 nonfinancial stocks in the U.S. That would be a radically different portfolio.
2) It's actually a death pool. The fund "expires" on the death of a list of named people. That can (and will) get adjusted over time, but it's a fun weird piece of trivia. There's no real danger or anything.
3) It's not cap weighted (even though they say it is a dozen times). It follows one of the most arcane methodologies in modern investing, which takes "overweight" stocks that pass a cap and then reassigns that weight to the smallest stocks, in a weird, iterative fashion.
It's truly bizarre.
But everyone should go listen to Trillions regardless; 'tis a great podcast.


Robin H.: It seems MJ is doing well, and I guess YOLO too. Therefore, are most issuers keen on developing cannabis ETF funds?
Dave Nadig: I think there's maybe room for another one or two, but I actually don't expect major issuers to wade in here at all. The regulatory issues (while largely solved by YOLO) are nonzero. And there's blowup risk should there be a big shift in the legal status nationally.
So I like having a little competition, and I suspect we'll end up with 3-4 survivors, sort of like we have in other niches.


Yves Martjin: Is it ultimately inevitable that robos will take over advisors’ role?
Dave Nadig: 100% nope!
I think robo platforms are awesome for people with straightforward asset allocation portoflios.
But there's nothing in any robo i've ever seen that even looks like what happens in a meeting with a good advisor.
No robo sits down and maps out your financial plan, or helps you consider the pros and cons of long-term care insurance, or whether to annuitize a distribution, or how to save for a specific event
or how to negotiate your ISOs.
A good FA does all of those things and much more.
So robos will be great for implementing a plan, but someone has to come up with the plan!


Todd Rosenbluth - CFRA Research: Hi Dave. There's a belief among active bond fund managers that with approx. 50% of investment-grade bond ETF assets in BBB bonds, when downgrades happen, there will be a lot of fallen angels into the junk category creating price dislocation. Can you help explain how bond ETFs handle downgrades? Also can you please put the amount of money in bond ETFs in perspective?
Dave Nadig: Big question. But yes, I agree. There's always movement in and out of the IG category.
I'm actually a big fan of the ANGL ETF from VanEck. Because often when bonds slide below IG, they get oversold.
So theres real opportunities then, since the cumulative risk of default isn't actually much worse between the worst IG, and the best Junk.
As to how IG funds deal with it, most have some way of buffering things. I don't know of any funds that sell everything the very day of a downgrade (some probably do). Sometimes it's just a waiting game till the next reconstitution. Sometimes it's an aging issue (sell in pieces over time) and so on.
I don't think this is a big systemic issue, as we've seen this rodeo plenty of times.
As for the money side:
U.S. bonds are currently at about $650 billion in assets out of a nearly $4 Trillion U.S. market.
The actual bond market is unbelievably massive, however.
I think it's well over $100 trillion in outstanding, which is like, 2X the global equity market.


Amanda Ling: Not sure how best to phrase this question, but basically, how much can/do investors go awry if they generally hew to home country bias?
Dave Nadig: Home country bias is a universal issue, but the U.S. is historically the very worst at it.
But it's not just us. Canadians put too much in Canada, U.S. investors put too much in the US.
The last stats I saw suggested something like most investors have 80% of their equity in the U.S.
I havent seen a recent set of numbers on it.
But in general, we should all assume we're overinvested in the U.S. And it's worse: Many investors overinvest in their employment sector too.
So tech employees buy too much tech "because they know it" and so on.
and they avoid, say, emerging markets, because it seems alien.
It's probably the biggest problem in most portfolios.
I'd say the other big one is barbelling. I know a ton of folks who have 60% of their money in one fund, and then the rest in cash, or one bond fund, with no sense of real global asset allocation.

So many questions today; just sorting out the ones i can get to in the next 10 mins.


S. Meryl: Now that Salt Financial is basically paying investors to buy their ETF, do you think this “gimmick” will start an ETF issuer trend?
Dave Nadig: I actually like the Salt guys, but I have to say, I think paying money back into a fund isn't a great precedent.
It's essentially saying "Instead of paying $50,000 for marketing, we're going to put the $50,000 in the fund as a gimick and hope the free press is worth more than the $50K.
I get WHY they're doing it, but it reeks of gimmick, unfortunately, and completely distracts from whatever the fund in question is actually trying to do, which is of course, MUCH more important than the expense ratio.
You could make a triple leveraged oil fund with a negative ER -- it still doesn't make it a good investment in my 401(k)!

Niles Vasquez: Should an investor wait to get into China ETFs til the trade wars are over?
Dave Nadig: Boy, what a tough question. I guess my answer is that any time you're making an event trade, you need to recognize you're fundamentally gambling, unless you have some reason to believe you know more, or know something different, than the collective wisdom of the entire market.
By definition, the price of China today contains the expectations of all outcomes weighted by probability.
That's what markets do.
So by all means, jump in, but recognize you're playing with fire. I feel the same way about buying a stock right before an earnings announcement.
It's basically the same play.
(As an aside, if you do make this call, make sure you know which China you want. A-shares are very different than, say, FXI, and perform radically differently over even short time periods).


Danielle: Have credit rating agencies always been “wary” about liquidity in the ETF market, or is this something pretty new? Is this even founded?
Dave Nadig: I think old-school bond folks are all very skeptical of ETF liquidity. Even very smart ones, and it's not dumb to be skeptical.
Bond ETFs have weathered a lot of storms, but the real issue is what they've "replaced" in some people's minds, which is the traditional bond desk.
That bond desk model gave people at least the illusion that on a no-good-rotten-very-bad day, someone would answer the phone when you were tying to unload $1 million of junk.
They don't necessarily believe that ETF traders and market makers will be there on that day (even though, historically, they have been).
But ETFs aren't magical unicorns. Yes, there's going to be a price on that day. But there's no guarantee it'll be a price you like.
(There wasn't in the old model either.)


Skip: Hey Dave, are "strategic beta" and "smart beta" the same things? Is it just me, or is there way too much jargon in the financial world …
Dave Nadig: There is way too much jargon, and despite what a given marketing person might tell you, the two phrases are used interchangeably.
So: Yes.
And its a HUGE umbrella that includes everything from value funds to crazy contango-beating futures black boxes.

OK, sorry to cut this at half an hour, but times a thing. So, last question here (and please come back and ask again! Or join the webinar next Thursday!)


Avery: Thanks for taking the time, Dave. When considering between 2 ETFs with the same or similar exposure, do you believe fees should be the deciding factor? We are seeing some fierce price competition with the big shops for broad market exposures, but I wonder if saving 1 or 2 bps is more important than other features of the ETF (tracking, securities lending, etc). Thanks.
Dave Nadig: So, I think it's safe to say, "all else equal," price should be a big factor.
But you're right to think that shaving a basis point is a bit foolhardy, because all else is rarely THAT equal!
Consider trading, consider structure, etc.
So yes, big chunks of expense? Yes. Shaving basis points is a bit silly.

Thanks for joining us everyone.

And hopefully we'll see you next week, either here again on Thursday, or on the webinar.

Have a great afternoon.

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