ETF Trading Tips & That Crypto ETF Patent

May 10, 2018

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


Dave Nadig: Hey folks! Welcome to this week's Live Chat!
As always, you can toss your questions in the box at the bottom, anonymously or for attribution, and we'll get to as many as we can.
We'll also post a transcript of this at the end of the day, so if you have to hop, don't panic.
Lastly, don't miss the weekly podcast at; we're having a lot of fun contributing to the great work they do over there.
With that, let's jump into our first question.


Danny from NY: Dave, why we don't have an ETF that invests in preferred shares issued by closed-end funds? (not CEFs that invest in preferred stocks but preferred shares issued by CEFs to obtain leverage)
Dave Nadig: So this is pretty deep-end-of-the-pool stuff. But for those playing the home game: closed-end funds will sometimes issued preferred shares as a way of raising capital to use leverage in their portfolios.
These prefereds are essentially bonds and can often pay pretty high yields. I won't claim to be an expert on the scope and breadth of that market (it's a corner of a corner of the market), but my understanding is that the actual floats here tend to be pretty small, and that can be a problem for an ETF tracking the space.
A lot of the preferred ETFs require ratings, and I think (could be wrong) a lot of the CEF preferreds aren't rated. Not all of them for sure, but the big ones.
I know that the VanEck Bectors Preferred Secutities ex Financials ETF (PFXF) goes pretty far afield, but I don't think it goes into prefereds issued by CEFs. That said, I don't even recognize half the issuers on a quick look, so it's certainly possible some of those holdings are CEF issued. I kind of doubt it for the size reasons above.
In general, it strikes me as perhaps "a niche too far" given there are only about a dozen prefered ETFs as it is. I think this remains a place where advisors actually often add some real value - cherry-picking individual yield vehicles for yield-sensitive clients.
It's a bit like managing personal bond ladders: a service that never really goes away.
Great question though.


Sean R: When trading low-volume ETFs with somewhat wide spreads, how should I be analyzing my execution? Which benchmarks should I be looking at for comparisons?
Dave Nadig: There's a whole industry -- at the institutional level -- on measuring and reporting execution quality.
It's a bit more art than science when it comes to less liquid securities. A short answer: if the spread is, say, 50 cents wide, and doesn't trade much all day, and you can get executed inside the spread, well, that's obviously swell (and often you can, if you're patient).
The second thing to look at is fair value. If the ETF you're trading happens to have an intraday NAV (INAV, or indication of portfolio calue, IOPV) that's live, (meaning, the thing you're trading has US underlying that is itself liquid), then you can check your execution price vs. that INAV.
That's really the best thing you could hope for -- a trade right near the fair value. If it's both illiquid, and the underlying is either illiquid (or international), then you're going to inevitably be a bit in the dark.
If you're an advisor or trader of reasonable size, you can actually call the capital markets desk of the issuer and ask for their analysis as well -- if you're big enough.
Wish there were a universal better answer here though - the T in ETF is a real thing.


P. Northfield: I just saw that the Winklevoss twins patented cryptocurrency ETFs. What does this mean for bitcoin ETFs going forward?
Dave Nadig: OOOh boy.
Man, that patent is DIZZYING. I read it through this morning and I think I need to scrub out my brain.
Hold for a link: 
It's being reported as some sort of "aha" patent that prevents anyone else from launching a bitcoin ETF (if the SEC lets them) but I interpret it a bit differently.
(And please, to be clear, the thing is MAMMOTH, so this is just a first glance. )
I think what's novel here and is really the subject of the patent is the custody system, where the presentation of bitcoin for shares and vice versa from the AP is done in a particular way.
What they propose isolates the existing assets from the transactions by moving the coins in and out of cold-storage wallets in an automated system.
I think this is an attempt to address security concerns from the SEC, but boy, it's getting deep in the weeds.
The most interesting part to me is seeing Kathleen Moriarty on the filing -- she's the original lawyer behind SPY, who I know has been working with the twins on their filings.
I'd love to hear them explain what pieces of this they think are novel in plain English.
But I think that's the important bit: Does it create a block? Seems unlikely. Most big financial process patents turn out to be reasonably easy to get around. (Vanguard's patent on ETF share classes notwithstanding).
I'm gonna answer this one, even though I have a feeling it was tongue in cheek:


Barry: What's an ETF ?
Dave Nadig: All kidding aside - believe it or not, this is a BIG question!
BlackRock has proposed a whole taxonomic system on this front.
And it's actually something the SEC has taken under advisement. The cold hard reality is that what we call an "ETF" is actually an exchange-traded SOMETHING - where the something can be a traditional '40 Act mutual fund, a '33 Act commodity pool, a piece of debt, a grantor trust, an unit investment trust, etc.
There are actually a lot of structural nuances, and the industry has sort of decided just to call them all "funds" and use "ETF" to cover them all. I mean, after all, it's our darned URL!
But I suspect as we look out a long ways - maybe 5-10 years - and have a true ETF Rule come from the SEC, we might actually see the term get regulated, where certain things end up in, and certain things end up out.
We've actually had to decide what to include under the bucket ourselves -- for instance, we don't cover exchange-traded managed funds (ETMFs) from Eaton Vance, because we think they don't check all the ETF boxes for us.
So, not actually a dumb question!


Bennie Jones: What 2-3 multi-factor ETFs do you think will do the best over the next 10 years in terms of total return?
Dave Nadig: Well, there's no way I can possibly be right here, but I would look for low-beta strategies that are primarily about risk reduction: I've singled out QUAL and DEF before.
Of course, if we have a 10-year bull market (or even just a flat, low-vol one), I would expect them to underperform.
I haven't seen any "magic bullet" strategy that claims to outperform in all market conditions that I believe in.
OK, here's a meaty one:


J. Gross: United States Commodities Funds just introduced a new fund - the SummerHaven Dynamic Commodity Strategy No K-1 Fund (Symbol: SDCI). This is essentially the same fund as the United States Commodity Index Fund (Symbol: USCI) but with a better structure (as a '40 Act fund). This new fund is cheaper with no K-1. Do you expect other established funds (WisdomTree Continuous Commodity Index Fund, (Symbol: GCC) and the PowerShares DB Commodity Index Tracking Fund (Symbol: DBC) to do the same and come out with No K-1 versions of these funds? In addition, is there any mechanism to simply convert a '33 Act fund into a '40 Act fund rather than having to introduce a new fund?
Dave Nadig: So a bit of background: traditional commodity ETFs like, say USO, are commodity pools by law, and as an investor, you're a "partner" in the pool, and thus get partnership tax forms (the K-1), which is, put bluntly, a real pain come April 15 each year.
To answer:
There's definitely no way to just "morph" a commodity pool into a traditional mutual fund. They're not even regulated by the same entities (CFTC vs SEC).
I supposed in some extraordinary circumstance you could do some kind of simultaneous dissolution of the commodity pool and distribute "proceeds" in shares of a new '40 Act fund, but I imagine it would require a LOT of shenanigans, and I doubt anyone would think it's worth it.
But it's also worth pointing out that the K-1 isn't always a bad thing.
The K-1 funds give you 60/40 blended long/short gains each year - you basically get treated the same as if you were a personal futures trader with "inventory."
But most commodity ETF strategies never hold a position for 12 months, so this is actually pretty favorable treatment -- at least SOME of your gain gets the LT treatment.
In the no-K-1 structures, all your gains get distributed as income, so you have simpler taxes, but probably worse tax treatment.
If you're investing with taxable money, you may actually be better off in the "old" structure, if you can handle the non-zero hassle of filing K-1 forms.
As for whether everyone comes out with one?
We'll, we've seen some of the no-K-1 stuff get traction, so if that's how the market wants to invest, I imagine we'll see most popular funds launch clones eventually.


Bill Donahue: Dave, as you know, the ETF market is dominated by the top 3 issuers. However, many large asset managers have entered the ETF market over the past 3 years. How do you expect the ETF market share will evolve over the next 5 years? Will the top 3 continue to dominate flows/AUM or are there opportunities for the other firms to cut into their market share?
Dave Nadig: Hi Bill. So, I think we'll continue to see mostly what we've seen -- strong dominance at the top of the chart. I think the midtier (issuers 3-10, say) will expand to include new players who get real traction because of distribution (like we saw with Schwab), so in a decade, maybe that 3-10 becomes 3-20.
But you either have to have a captive audience/brand, or you have to have a better mousetrap.
Which is why I continue to think the big threat is not, say, Gabelli, or American Funds, but Google or Amazon.
They have distribution and brand, for sure.
Imagine getting free asset management with your $120/year Amazon Prime subscription!
I mean, it makes me chuckle, but maybe that means we should all be worried about it!


Toby Loftin: How do you define ‘energy,’ and do you view it as a trade or an investment? If a trade, then what inning are we in? If an investment, do you know of an ETF that approaches investment in 'energy' in a balanced fashion including other industries that potentially benefit from increasing economic activity reflected in oil prices?
Dave Nadig: So how *I* define energy isn't all that important, because it's how the financial industry defines that determines your exposures.
In short: oil.
I believe the broadest portfolio tracking energy is Vanguard's (VDE), which has something like 150 companies in it, but it doesn't matter much, because it's cap weighted and thus is the Exxon/Chevron portfolio like everyone else's.
The big integrateds and a few of the service companies (Schlumberger, for instance) just dominate by market cap. So unless you explicitly exclude or cap them, dabbling in, say, transports and such, it won't move the needle much on your exposure.
So if you really want more diversification, you have to combine, say, solar and wind, and MLPs and so on, to create some of what you're talking about.
The building blocks are there in ETFs, but nobody's made a combo platter for you yet.
As for whether it's a trade or an investment -- I just see it as a sector.
If you go heavily overweight, you're definitely making a call. It's about 6% of the global economy, so if you make it 12% of your portfolio, you're for sure making a trade.


Nicholas Stein: I would like to follow ETF funds flow. Is there a free source of ETF funds flow or creation/redemptions I can download daily as a csv or Excel file?
Dave Nadig: Hi Nicholas - so we have a fund flows tool here, which we source the data from FactSet for, but we don't have license to distribute that out.
It's surprisingly complicated and messy data, so in general, nobody's going to give it away, as it takes real effort to maintain and clean (adjusting for splits, fixing NAV errors, and so on).
The two main approaches are the FactSet approach and Bloomberg's approach.
Both will SELL you the data, but not give it away, I'm afraid.
So, short of tracking it by hand every day from our tool, I don't have a free solution for you.
(FWIW, there are real decisions about timing you have to make to get apples/apples, which is why sometimes you'll see different sources disagree on a given time period).


Guest: What do you think of using net flows for ETFs, for example, net flows into cyclical versus non-cyclical sectors, to gauge investor interest in those sectors?
In other words, would large net inflows for financial sector funds be indicative of optimism about the sector?
Dave Nadig: So, to be super specific:
The flows represent when there's been enough buying or selling to create an arbitrage for the AP to make or get rid of shares.
So in that sense, flows is a reasonable measurement of "buying pressure" or "selling pressure"
You can have ENORMOUS volumes -- a measurement of interest -- and very little flow, which implies buyers and sellers are finding a matched price a lot.
So, short answer -- yes, it's indicative of that buy/sell pressure. BUT... because of a lot of nuances in how the data is reported, I would only ever  look at this over a decent time horizon -- weeks, or a month, for instance.
On a day-to-day basis, the data is subject to all sorts of noise.
For instance, Elisabeth Kashner at FactSet wrote a great piece on how you can find paired creation/redemption activity offset by a few days that don't represent anything around sentiment, but are mechanical offsets from index rebalance trades.
Those wash out over a week or a month, but if you looked at just a day, you would erroneously think "Everyone's in!" and then "They all left!"
Great question.


StephCurrie: Could you explain what the yield on an equity ETF is? Is that the dividend? You can ask stupid questions, right?
Dave Nadig: No stupid questions!
So, generally there are TWO yields for an equity fund. The one you generally care about is "Distribution Yield," which imagines, say, SPY, as if it were a stock.
So SPY's distro yield is ...
That means, on a trailing basis, you got $1.81 in dividends for your $100 investment, same way you'd think of MSFT dividends.
If you click on the "Fit" tab for SPY though ... 
... you'll see a different yield, which is the portfolio yield. That's the trailing 12-month dividends of everything the fund holds.
Why don't they match? Well, holdings change! Whether rebalances, or just cash positions, and so on.
They rarely, if ever, match perfectly.


Invisible Octopus: Do the wirehouses have to disclose their relationships with the fund companies? Where can I find that info?
Dave Nadig: Nope! Would be nice if they did, but I have never found any source. There are a few ways it plays out ...
Fund companies can rebate back to a broker for presence in a no-transaction fee program (say, an issuer pays Schwab 25 basis points on assets there, to be in their NTF program).
They can simply write a check as part of a marketing arrangement (Here's $50,000, we'd like to be on your select list).
They can also do much "softer" things like support conferences (Here's $50,000, we'd like to be the silver sponsor of your annual event).
How clean and obvious those relationships are is a subject of a lot of debate and discussion.
But if you're the wirehouse customer -- ASK! You are the customer after all. Perhaps they'd tell you!
(Note: there are rules about some of this, that are enforced by FINRA, so it's not a complete wild west. But disclosure? Not so much).


Guest 2: Since ETFs' holdings are transparent, how do you feel about shadow investing based on viewing the underlying positions of the ETF, say, an actively managed ETF that has 15 holdings? Rather than paying the high expense ratios, just shadow the holdings and save on costs?
Dave Nadig: Well, this is certainly the argument that active portfolio managers will make when they explain why they don't disclose their traditional mutual fund portfolios.
For the most part - I don't believe it.
If you think Jane Doe is such a genius that her active 15-stock portfolio will outperform, you probably believe not only in her stock selection, but in her timing.
So, if you REALLY want to check in every day and see if she decided to dump AAPL yesterday, well, I guess more power to you.
However, it's worth noting that, by convention, ALL reported holdings are actually lagged. So if she sells RIGHT NOW, tonight's portfolio won't actually even show the sale. That shows up the next day.
(That's not an ETF thing; that's a mutual fund convention we all inherit).
So you sort of have to believe timing doesn't matter much, at which point, I guess, sure, you could shadow her.
But I'd be surprised if you actually BEAT her at the end of the year, given differences in timing and execution (her costs will be lower than yours).

OK, I think I'm going to wrap it there. Sorry if I missed a question; we'll hold it for next week.

As always, a transcript will be up shortly, and you can check in after 9 a.m. each Thursday to submit questions.

Have a great day and a great weekend!

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