Bond ETF Liquidity & QQQ's Strange Popularity

May 17, 2018

[Editor's note: Live Chat! with Managing Director Dave Nadig happens Thursdays at 3:00 p.m. ET, with the question window available two hours before and during.]


Dave Nadig: Hey folks, welcome back to Live Chat! 
As always, you can post your questions in the box below, anonymously if you like. And we'll have a transcript up later this afternoon if you have to hop out. 
Let's wade right into the questions. Good mix of 101 and more esoteric stuff, it seems.


Sean R: How do you measure implied liquidity for a fixed income ETF? Are there any liquidity issues I should be worried about in this space? 
Dave Nadig: Boy, talk about a thorny question. 
I wrote a piece last week on how junk bond ETFs will respond to a crash, and this issue of implied or underlying liquidity remains super thorny. 
For equity ETFs, it's pretty straightforward. You can look at the dollar volumes, you can compare that to, say, how much of each stock you need to build a basket to hand in to create new shares, and soon. 
We display FactSet's model on our fund pages, Dave Abner built a different model for Bloomberg, but ultimately, it's a knowable problem. 
But with bonds, it's intractable. Broadly speaking, there are "things you need to worry about" and "things ya don't." 
Treasuries, agencies, even developed market sovereigns, you really just don't need to worry. ETFs are such a tiny part of that world, it's irrelevant. 
Junk, munis, EM debt, it gets much trickier. Something like HYG trades $1-2 billion a day but owns bonds that literally won't trade today. 
So the long-winded answer here is "you really can't" -- all you can do is know that, as a class, you're investing in something that is more or less liquid, and exercise the appropriate caution. 
I say that a bit flippantly, but we spent quite literally years trying to come up with a systematic way to do this, and you run into big roadblocks very, very quickly.


efims: What are differences between ETFs and ETNs? 
Dave Nadig: This is a question I can ACTUALLY answer! 
So, we use "ETF" a bit like people use "Kleenex" -- overly broadly. But the core distinction is between pooled vehicles that actually own securities, and debt. Anything that actually pools securities is a fund (in my book) - so that includes things that are UITs (like SPY), or '40 Act mutual funds under the hood (like most ETFs), or grantor trusts (like GLD). 
I also include things like commodities pools (say, USO), which are differently regulated, but are still ultimately just pools. 
ETNs are notes -- that's the N. So a big bank issues a piece of debt. 
But it's just like a corporate bond.
No different than if they just issued a bond for their own financing.
The difference is they promise to pay a pattern of returns tied to some outside index -- say, 3X the return of the S&P 500, or something. 
But ultimately, it's still a bond, and it could still default. 
Assuming it DOESNT default, it has aspects (like creation and redemption) similar to an ETF, that allow it to trade on an exchange, close to its fair value. 
As an investor, they can give you access to some interesting patterns of return, but know you're really just buying some bank's bond. 
(Taxwise, it gets treated essentially just like a stock, which can be a good thing for, say, commodities investors).


Ada Lovelace: I read Cinthia Murphy's piece on the most searched for ETFs and I can't figure out why QQQ is still so popular, even when other tech funds have better performance. Is it just because QQQ has been around for forever? 
Dave Nadig: Ah, the Qs.  The thing is - they became the "easy button" for tech investing back in the 1990s. 
For a brief period, I was a mutual fund manager, and even *I* used the Qs as a quick way to try and catch a rally in big tech names. (This was back in the '90s, and I learned my lessons!) 
So yeah, you kind of hit it - there's a historical connection to it.  And it's maintained just crazy good liquidity, so it really does serve as an easy-button trade. 
They've rejiggered the underlying index (I wrote some pretty scathing articles about it at the time) to keep it investable, and the actual methodology is SO arcane it would give Dumbledore a run for his money to explain it briefly. 
But mostly, it's a historical anomaly like the Dow Jones Industrial Average. 
Over time (a long time), I'd expect it to continue to slowly lose share of mind, but it's probably a literally generational change that would have to happen.


Evan Martin: Hi Dave, Need ETF investors pay as much attention to world events as stock investors do, in terms of impact on investments? 
Dave Nadig: Hi Evan!  So, interesting question.  I would say it depends not so much on the vehicle you're using as the narrowness of your exposure. 
If you invest in, for instance, the entire global equity market through something like Vanguard's VT, well, it sort of doesn't matter how the UK is doing vs. the US, because you're in both.
A bit narrower, let's say you're heavily in US stocks, and have a very small international position, well, you need to probably pay a BIT more attention, if only to rebalance those positions. 
A bit narrower, let's say you load up on the Qs from the above question, because you like tech stocks? Well, now you have to pay even more attention, and so on. 
That's true if you use ETFs or mutual funds, of course. 
But in general - the narrower your exposure, the more it behooves you to pay attention, even if it's only for basic portfolio maintenance - reinvesting income, rebalancing, etc.


M. Jemison: In what instances are ETFs actually the worse investment choice between ETFs and mutual funds, or something else? 
Dave Nadig: Great question.  In general, if you're not comfortable with learning the basics of trading, ETFs may not be for you -- you DO need to learn to make trades, use limit orders, accept the variability of pricing in the middle of the day, and so on. 
Second, if you're dollar cost averaging small amounts frequently.  Say you put 100 bucks a week into an IRA, or your employer contributes to your 401(k). 
All those trades -- even if they are comission free -- can add a lot of friction to your portfolio. 
With a mutual fund, you can both get the assurance of end-of-day NAV, and you can invest in whatever small-dollar amounts you want. 
And of course, if you shop around, you can get pretty-low-cost, index-based mutual funds, like you see in most of ETF land. 
So why bother with ETFs?  Well, increased transparency, generally lower costs, and better taxes.  And of course, trading is a boon for some investors.


Todd Rosenbluth - CFRA Research: Looking forward to our Inside Smart Beta panel in June What smart beta ETF is flying below the radar to you? 
Dave Nadig: Thanks for the plug Todd -- yes, that should be a fun session at Inside Smart Beta in NY next month. 
Sumit Roy just did an article for us on the raging small-cap market (one sec for link): 
and the one that jumps out at me there is the First Trust Small Cap Growth AlphaDEX Fund, FYC. 
FT was actually one of the first real "smart beta" players, and they offer just dozens of factor and multifactor products, some of which have been real winners over time. 
FYC is a pretty standard growth fund in what it looks at: price-sales, sales growth, momentum, etc. 
But it's a pretty active methodology. 
And it's really just CRUSHED a lot of other approaches to the small-cap growth sector -- it's high beta, but that's kind of what you want if you're taking a flier on little growth companies. 
I think "smart beta" can often be most effective in the corners - like small-cap growth, and that's the best example I've seen in a while. 
Of course, high beta means if small caps go south for 6 months, you'll get crushed in the wrong way, but that's the price of taking a flier ....


Sallie Lockwood: Hi Dave, Is that proposed fiduciary rule completely dead in the water, or do you envision it being resurrected? What are plusses and minuses you see, either way? 
Dave Nadig: Hi Sallie -- well, it's not COMPLETELY dead.  My understanding is that the DOL basically let it die at the end of April. 
(There was a court case and they lost). 
But, several states (CA and a few others, if I recall) are independently trying to revive it. 
I think in general we're at an interesting place on this front -- I could see states getting pretty aggressive here, essentially taking things into their own hands. 
We've seen the SCOTUS supporting that recently with other rulings. 
So while the DOL rule may be dead (and the SEC rule is better than nothing, if it happens), I could see, for instance, NY and CA having their own versions. 
The end result would be that most national brokers (which is the vast majority) would likely just work companywide to the highest-common-standard. 
In reality, a LOT of company policy was already changed a year or so ago just on the presumption that the DOL rule would go into effect, so a lot of the good that would have come from full implementation has already been "banked." 
That could erode, of course, but these things move slowly, and it's hard to un-wind something that's an investor benefit. 
Great questions, a few more and we'll wrap it up.


Anonymous : I can’t recall your past ETF assets prediction. Was it $10 trillion in 2020? Or pass mutual fund assets in 2025? Anyway my question is: are you on track? Also, do you watch Billions? If yes, did you catch the ETF/index reference a couple episodes ago? 
Dave Nadig: So, the core prediction is passing mutual funds by 2025, which gets us to I think 15T?  We've made various versions of the chart over the years -- but never lowered it.  We've been right on track year after year since Matt Hougan and I made those predictions back in 2009.
The flows have continued. 
And continue to be strong -- this year is less than last year, but we also had a less-than-bull market this spring. 
Mutual funds continue to be stagnant, etc. 
So I think we're on track, assuming no MONSTER corrections.


Grace Hopper: Why don't all the issuers who want to launch bitcoin ETFs just make a fund that puts all its assets in GBTC? 
Dave Nadig: Well, among other things, GBTC isn't really direct bitcoin exposure in the sense that you get guaranteed 1-for-1 tracking of it. 
Second, there are SEC diversification requirements -- you can't make a fund that just buys all of one thing.  You can do it in things like a commodity pool, but the IRS and the SEC have some pretty strict rules around it. 
Last, let's not forget that GBTC isn't even exchange listed -- it's pink sheet.  That created huge issues for most investment firms and boards. 
So even the one fund that I know invested in GBTC -- I think it's ARKK, or it could be another ARK investments ticker -- has a pretty small position. 
Also, the SEC made it pretty clear they're paying attention for anyone trying to dodge the rules here. 
(If I recall, ARK may have even unwound their GBTC position recently.) 
OK, I think that's going to wrap it for today.  We'll have a transcript up shortly, and don't forget to tune into for the weekly podcast segment as well. 
Thanks everyone, and we'll see you next Thursday!

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