Dave Nadig @ Future Proof: Video & Transcript

Transcript

Introduction

My name is Dave Nadig. I have 20 minutes and I'm already behind. There are three things I want to talk about today: Cheap - all of the money that anybody cares about is going to continue to flow into very cheap ETFs and there's nothing the industry can really do about that. Fat - that does not mean that everybody else in the industry isn't making an enormous amount of money, which in fact they are. And starving for attention - this time next year we could have 9,000 ETFs. That makes everybody's job really miserable because you have to wade through that to find out what's actually worth happening.

Speaker Background

Why should you care what I have to say at all? I've written a couple books on ETFs. That's a QR code that probably won't render, but you can go to the CFA Society and grab it. I've also been in the ETF industry since before there were ETFs, back in 1992 when I started building what became the iShares product, were then called WEBS. But also I'm the guy in the little booklet if it's in your bag here. That's my self-portrait. It's not my best work.

Why am I talking about it? Because part of what I want to talk about is trust, and I think the way you engender trust is what we're doing here, which is being actual human beings. Being a little vulnerable, and that is not what the ETF industry has in store for you. I hate to tell you that.

I probably need to mention that I have a new job as of eight days ago. I'm the new president director of research at ETF.com. It's my fifth title and third job at ETF.com in the last 15 or 20 years. I see a couple of ex-employees out here as well.

ETF.com's New Direction

So what are we doing and what's going to be different? Well, we don't have it all figured out. It has been about a week and a half, but I can tell you what we're not going to do. We're not going to write a lot of content about how to play this piece of news with that ticker because I think that's better done by AI. I do think we're gonna write a lot of very human content about what's actually going on in this industry.

When Matt Middleton and I had our first chat about this, he said the editorial guidelines should be something like: we're going to tell investors what's actually helpful and we're going to tell the industry what they need to hear. And I think we're gonna do both of those things, and I think that's better for investors and it's better for the industry.

Part of how we're gonna do that is by building a community of people to talk to each other about this stuff. Some of that's gonna happen in places like this, big events. Some of it's gonna happen virtually. Matt's got a couple of cool ideas up his sleeve as well. So a lot more to come over the next year and change as we figure out what our real go-to-market strategy for a new, better, enlivened ETF.com is going to be.

ETF Industry Overview

But that's not what you're here to talk about. You're here to talk about the ETF industry, and I'm gonna test everybody on all these numbers. No, I'm not. Look, we're at about twelve and a half trillion dollars. We had eight hundred billion dollars flow in this year. That's five billion dollars every single day.

The real story of this year is that 37% of that went into things called active. They're not really active, they're active in name only. But that's huge because this is a passive industry. This is a cheap beta industry. So what's going on? Is this really a movement back towards active management?

Well, when you get under the hood it's a little more complicated. Almost all of that flow is going into these things called non-traditional, a great category that ETF Action came up with. Synthetic income, if you read across that - synthetic income, year-to-date flow revenue, three hundred and sixty-six million dollars. That's the amount of new fee revenue from flows this year into options-based income products. That's enormous, right? That's just a big number. It's worth paying attention to.

Leverage and inverse and buffers, the other two big ones. And a lot of this is called active management and certainly charges active management-like fees, but it's not the kind of active management you're gonna get from like Tom Lee down at Fundstrat where he's picking stocks. That's not what we're talking about. We're talking about trading active because options are hard to index.

The Evolution of ETF Launches

This is in fact a new great chart from Todd Sohn at Strategas. This is just assets going this way and number of launches going this way, and lo and behold, all the things that have the money don't get a whole lot of launches anymore because that field is already taken. Instead, it's all that leverage and inverse. It's all that synthetic income. It's all that buffered product. That's where the funds are coming and that's where the fees are coming. So that's the background.

Cheap: The Fee War Reality

So let's get into cheap, fat, and starving for attention. What's cheap? Well look, this is where the flows are year to date, and all this stuff here on the left is under 10 basis points. That's the cheap stuff. So despite the fact that 37% active sounds like a big flow number, the vast majority of the money will continue to flow into these extraordinarily cheap products. And if you go all the way out to the right, it just doesn't look like there's any point in being in the expensive industry. That's not really that true.

But we are seeing overall this trend towards lower and lower fees. I would say we bottomed out here. This is the Morningstar chart of fees - active and passive mutual funds are on the top two lines and all the ETFs are on the bottom. You'll note that we started to see a couple of those lines kick back up. I think we may have reached the bottom on the fee wars and honestly that's probably fine. I don't think anybody really needs to worry too much about whether something costs 9 basis points or 11. It's not going to make that much of a difference. So we've kind of bottomed out the fee war here.

That means the folks who were already here and already very efficient are going to continue to be the ones getting all of these assets going forward. We all know their names, they're all around here.

Fat: Where the Money Really Is

Let's get to the fat part. That was assets, which is how the industry tends to keep score when we go to parties. It has nothing to do with whether or not anybody gets a bonus. This is the actual revenue. This is just a one-month chart. If I could mechanically click through, I could show you it looks pretty similar for three-month flows or assets under management.

The amount of money being collected by that smaller group of very expensive funds is overwhelming. That is where the bulk of the profit in this industry is being made. Now it doesn't mean that there's no money to be made elsewhere. There's a belly of that curve which peaks at 31 to 40 basis points. Lots of great products there that are also generating lots of great fee revenue for those folks. But the expensive stuff is just kid in a candy store money.

And if we get under the hood to see who's really doing it, this is what's in that synthetic income bucket. It's actually really two firms. It's JP Morgan and Toroso. Toroso being YieldMax in this case. And I love these guys. I have nothing negative to say about Toroso, which is TIDAL and YieldMax, nor about JP Morgan. Hamilton Reiner is fantastic. I think he's one of the best managers out there in the market right now. They're also collecting 250 million dollars in fees on basically one product, JEPI. So it's important to know that because that's your money you're spending.

Same thing with the YieldMax products. Hopefully not very many of you are putting your clients in those types of products, but it doesn't really matter because another quarter of a billion dollars in fees getting thrown off those products year after year for managing options. So that's where the fat is there.

On the buffered side, fees are down a little bit from the sort of crazy income stuff. But again, really a race of two players: First Trust and Innovator. First Trust being the FT Vest products. And again, you can see the revenue - 300 million dollars for First Trust on the back of those FT Vest buffered products. 215 million for Bruce and his guys at Innovator. God bless them. I think they're interesting products. I'll talk about them in a minute. But again, they're a handful of firms that are not BlackRock, State Street, Vanguard that we all know that are actually making all of the money in the market right now for ETFs.

The Derivatives Revolution

And we're gonna see more of this. This is really the story of opening up derivatives in ETFs. This really kicked off in November 2020 with the new SEC derivatives framework. And that's what's opened up this floodgate of new product. Now basically all you have to do is come up with a liquidity management program, get your board to sign off of it, and you can do almost anything you can possibly imagine with options at this point.

I don't really think it goes much further because there's not much left. We're already trading OTC swaps and options. We're already trading every interesting futures contract. Until we get perpetuals in an ETF wrapper, I don't think we can do much more derivatives than we're already doing.

ETFs as a Platform, Not a Product

Which gets me to a sort of pause here. ETFs are no longer a product. They're a platform. It used to be that they were a product. You could say ETFs and people sort of knew what you meant. Now it's like saying I have a phone. It doesn't mean anything at all. It tells me nothing about you or what you could do for me in that moment.

And like every other platform we've all gotten familiar with, the only thing that matters is attention. And as a platform that's about to be flooded, all we're gonna see is more and more ideas wedged into the ETF wrapper. And that's great because the ETF wrapper is in fact the best possible way to get an investment exposure into the hands of somebody trading. It's the most efficient vehicle we've come up with yet. The problem is it's just an empty shelf for ideas, and increasingly most of those ideas just suck.

The Trust Problem

So what do you do with that? Well, I think that we now live in a black hat world. It used to be ETFs you could say that's a product I understood it. It also used to be you could kind of count on it because there was an industry, it was small, nobody was gonna do anything really stupid because either they were gonna get fired or they'd get shamed or somebody would write a nasty article about them and that would keep people from doing the worst stuff. Or at worst there were norms like "oh we just don't do that." You wait for the SEC to tell you whether you can file your product. Turns out there isn't a law so you can just get away with it now.

So that issue is endemic throughout all the relationships advisors have. So what do you do? I think you have to become very stingy with your trust and I think you have to base it on actual people. Now it doesn't mean you have to take your wholesaler to dinner every three weeks or he doesn't have to take you to golf every four, but it does mean if you're gonna put a bunch of your clients' money in something, there better be a person that you know that you can talk to if something goes wrong with that product.

It doesn't have to be every day, but you need to have some belief that there's a person that you've used your discernment as a human being and said "aha, this is Bob. I trust Bob. Now I'm not gonna give him my kids for the weekend, but I don't think he's lying to me." That is human discernment and that is something that has largely gone absent from this industry over the last ten years.

The last thing I would say is keep your laser handy. What I mean by that is please don't be afraid to fire managers. Not everybody that you've been working with for five years is the same as they were five years ago or ten years ago, and if they start doing stuff that doesn't feel right for you, trust your instincts on this. I think this is a trustless market and that puts you in a very tough position.

Case Studies in Trust Violations

Let's talk about some of those trust violations and where I think they're sort of baked in and you can't do anything about them.

Leveraged Products and Volatility Decay

This is QBTS, D-Wave Computing. I love - anybody wants to talk about quantum annealing later, I'm your guy. Love this stock. The day that it came out, it came out with a 2x leverage version within a day or two, and that 2x leverage version traded like bananas and traded up to 400% at one point and then came crushing back down.

This is a product that did exactly what it said it was gonna do every single day, and yet 107 times 2 isn't 161, it's 214, because this is a daily reset product. And I feel dumb saying this because I've said it every year for 20 years: you can't hold daily reset products for more than a day without having wildly weird performance. This is the absolute poster child for this.

This is MicroStrategy, and those things that are down 30%, those are the 2x up ETFs, not the 2x down ETFs. This is volatility decay. So if you've been dumb enough to hang on to MicroStrategy levered for three months, your plus 30 that you thought you were gonna get turned out to be minus 30. That's a 60% performance gap. The fund did exactly what it said it was going to do every single day. The problem was the idiots who bought this thinking that it was going to give them long-term 2x exposure. And if you think I'm wrong, just go read any subreddit about this stuff. There are thousands of people who don't understand this, and if you tell them, they will yell at you.

Income Products and Tax Surprises

The income products are another place where I think they're just not doing what people think they're gonna do. A lot of these YieldMax products have been sold as income vehicles for people who are trying to solve an income problem, which is usually like a retirement problem. But these are generally pegged against stuff that are so volatile I don't think I could stomach owning them for the length of a dinner, much less a portfolio. And yet we end up with folks going into these over and over again, not realizing they have utterly unpredictable taxes.

I didn't even realize how bad this was until my friend Brent Sullivan, who's here somewhere, pointed out to me that return of capital can be really helpful, and a lot of times these income products seem to be giving you tax-free money except you have no way of knowing until the day you pay your taxes. MSTY, the biggest fund here, its 19a-1 projections of how your tax was going to be treated at the end of the year were a hundred percent "we're gonna return capital" until six days before the 1099 went out, and then it was 100% current income.

If you didn't plan for that, you had a really rough conversation with your attorney and your tax guy. And this is not just gonna get easier, this is gonna get harder. And you'll never know because of the way this kind of tax treatment has to be done legally, it is utterly unpredictable what you're gonna end up with at the end of the year.

And so you end up with this - and I keep a little folder full of weird charts and stuff people say on Reddit that I think is interesting - and you get a lot of this: "I want to go into MSTY because my 86-year-old mother needs more income." My 86-year-old mother has no business even knowing that MicroStrategy exists, let's be really clear about this, and she certainly should not be augmenting her social security with putting all of her money into MSTY. And incidentally, what you end up with is a lot of what's on the bottom of this: you end up with all the people who think it's gonna go to the moon, and then all the people who had some terrible experience then getting flushed out of the ETF market. It's a continuous problem.

Private Credit: The New Fad

Private credit is another one that you're just gonna hear over and over about. It is the fad of the week. I tried to put Beanie Babies up here and Matt Middleton told me I was ancient and had to put a Labubu up here. Doesn't matter what your fad is at the moment, it's private credit.

Again, nothing against the folks here at State Street. I think they run an amazing business. But this is the only product in history that was launched against the express wishes of the regulator. They got away with it because there was no real way to pull it back once they did it, but they basically just launched and dared the SEC to tell them to take the product down. That's not how innovation is supposed to work. I understand everybody wants to innovate and get new product out there, but when you're running counter to the very regulator you're supposed to be working with, I don't know, it's very hard for me to see all this private credit stuff as any more than bag security for folks on the private credit side that would just like to get some money back so they can go do this thing again.

I'm not anti-privates, but you should always ask yourself the question: why am I getting access to this? Because you know that there's somebody who had a decimal point on you who got access to something different. And unless you have a really good answer for why this is still a great product, you should assume that you are bag security for somebody else. You're bag liquidity, that's all it is.

I'm not panicked about these products. We're not going to get a ton of them. I think there's some interesting structures. Interval funds are actually great - you should go look at them if you want to get into private credit. I think what Capital Group and KKR are doing there is a better way to approach this problem.

Buffered Funds: A Nuanced View

Buffered funds - I think buffered funds in general are pretty great. There's been a big kerfuffle on the internet about them. Cliff Asness and Karan Sood and Elizabeth Kashner from AQR, Vest, and FactSet respectively kind of got into this match on Twitter and various posts about "buffers are amazing," "buffers are terrible," "buffers are academically unjustifiable," "buffers are the best thing since sliced bread." And they're all right. They're all approaching the idea of buffered or defined outcome from their own lens.

From an academic perspective, absolutely there are better ways to achieve these kinds of exposures if you have infinite access and infinite patience and infinite intelligence. But as an advisor, a lot of times what you have is somebody who's 67 years old who's feeling really nervous about being in the market, and you know they probably need to stay invested in the market. Well, guess what? A buffered product might solve that conversation. Doesn't necessarily make the portfolio magically perfect, but it might help that person make a difficult decision that otherwise might just be too hard for them. They need a little insurance. Sometimes people buy insurance for bad reasons, and it's great because it gives them emotional support. That's what buffered funds often are in this conversation.

What's Actually Innovative and Good

All right, two more slides and then we're out of here. What do I think is actually innovative and good?

Bitcoin: Hey, I love the digital gold story. I love the alternative to fiat. I also think that throwing all your money in Bitcoin is profiting from the wound that is America right now, and I'm not willing to do it, but you be you. I think the funds were great, and I think that we're finally getting bridged to crypto and that's awesome. I do think crypto is the future of finance. I do think there are massive efficiencies to be gained, but I think it's really tough when the grifter-in-chief is kind of getting underneath the skin of this industry every five minutes. It's not helpful. So pros and cons.

Leverage: Some leverage is great. I love what things like return stacking and those kinds of portable alpha strategies are doing. They're worth the look. Most of it is degenerate gambling. Single stocks? I got nothing - degenerate gambling top to bottom. There's no reason those products should exist.

PE and Private Credit: Democratizing access? Okay, I get it, sort of. But mostly bag security for stuck money.

Options: I used to trade options as an active portfolio manager in the 90s. I love options. They're fantastic for modeling your return pattern and getting exactly what you want. That's not what we're selling. What we're selling is zero data exploration, degen gambling products. But there are great things that we can do with these options.

Future Concerns

And then last, this is the stuff that's actually keeping me up at night that I haven't figured out how to write about well enough.

The first one is we've got probably three to four thousand new products coming because mutual funds are going to get to launch ETF share classes. That is neither good or bad unless your job is to analyze ETFs for a living, in which case it's just bad. No, we'll get some great products from that transition. I'm not down on all of them, but it's gonna be a flood and it's gonna change the industry.

I'll skip the OCC for a minute. I think our very strong anti-merit regulatory structure - which is what we are, the SEC says all the time "we are not a merit regulator," they will never say a product is good or bad - what that's meant in our deregulatory environment is that anything goes. And lots of products that should not, for very good structural reasons, get launched will absolutely get launched. That just makes all this trust stuff even worse.

I think places like swap spreads are containing a lot of grift right now. There's a lot of product getting launched that uses swaps that's actually baking in a whole lot of extra management fee. It's impossible to tease that stuff out, so I'm a little bit nervous about some of what we're seeing in the swaps market.

Passive effects are absolutely real. I write about this every six months on a calendar. I've been doing it for ten years. Yes, index funds are the best thing we've ever invented in finance. Yes, they impact the very markets they're working in, and we should not put our head in the sands about that.

And then last, all this movement into options, which is really just enormous - the volumes are just insane if you haven't looked - all fall on the back of a single settlement fund at the Options Clearing Corporation for when somebody really goes under in a big hurry. Now that's actually huge compared to other clearing houses in the world. The OCC is probably the best funded and the best run, so it's not a dis on them. But the problem is we still use end-of-day margin, and we've never really tested all these ETF options-based products. So that makes me a little nervous. It's not insane to think something could blow up between 12 and 2 in a given day, and you're still stuck with the clearing fund that you had last night. Those are real issues.

Closing

All right, I'm about a minute and a half over. I know people have to go to meetings. Thank you all very much for coming out, and I'll see you around. Cheers!