Leveraged ETFs Here To Stay & Finding An Int’l Fund

April 26, 2018

[Editor's note: ETF.com 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, thanks for joining ETF.com Live Chat!
I just jumped off a webinar, so coming in hot here. Let's get started with a super easy one.
(As always, we'll have a replay up shortly after this, and you can always enter questions anonymously as we're going)

Ehud: Is there any ETF for cobalt?
Dave Nadig: Super easy: nope.
But the longer answer: There are a bunch of narrow commodities and such where we don't have good products, but usually for good reason, like, there's no good way to invest in steel directly.
That's more a function of the underlying market, and it being tough to securitize.
in the case of cobalt, or even rare earth metals, the reality is the markets are so thin that the demand likely wouldn't be there.
 

 

Ira Artman: I thought I read somewhere that leverage was not permitted in the design of indices that were permitted for ETFs. (Perhaps in May 2017 ETFReport?). How then do we have leveraged ETFs, with all degrees of leverage?
Dave Nadig: You may be remembering the back-and-forth with the SEC on the 4X leveraged S&P 500 ETF that was filed about a year ago. That was approved, then unapproved.
Similarly, there is still hanging a proposed limit on the use of derivatives to generate leverage, which would effectively have created a cap of 150% derivatives exposure, and thus 250% total exposure.
This would make 3X funds either go away or be quite tricky to manage (there's some clever math that could probably keep them alive).
But that's all by the wayside at the moment.
I don't think there's a lot of momentum to implement these rules right now (or the liquidity rules that were proposed.)
(Now someone will prove me wrong, but I don't think there's been much movement.
We continue to see products get filed and come to market. And with exchange-traded notes, issuers can kind of launch whatever pattern of returns they want. Heck, BMO launched the 3X FANG stock ETN this year (FNGU) and it has like, $50mm in it!
So in general, I believe that if investors want to put money in it, the industry will find a way to make it, unless the regulators step in with strong will.

 

Guido: I was looking to the overview of the theme ETFs and missed the SOCL from Global. How is the list composed, to understand why some ETFs are not listed? I found via your tool 64 theme ETFs.
Dave Nadig: Hi Guido -- yeah, this is a bit of a tricky one. There's really no common way of defining what a "thematic" ETF really is.
in general, the methodology is that themes cross sectors.
So if a fund is really just, for example, a tech fund, but with a thematic name on it, the FactSet methodology will call it a tech fund.
But it's a reasonable point. There's a similar issue with ESG.
I mean, "solar energy" is a legit segment of the market, regardless of whether it's an ESG fund.
so do you call it ESG? Even if it doesn't itself call it ESG?
I wish I had super clean answers for it, but it's these edges that keep me up at night. But also make the space interesting!

 

An Investor: Thanks for the 101 Webinar, it was super helpful. One lingering question I have ... do I actually have to care about what's going on in terms of creating/redemption? Does it actually matter to me?
Dave Nadig: Drew hit on this a bit, but the short answer is - not really.
Your individual trades of 500 or 100 or even 10,000 shares aren't directly going through the creation/redemption process.
Theoretically, you're just part of the pressure on prices in a given day. If you're buying 100 shares, and thousands of other small investors are buying 100 shares, well, you'd expect the price of the ETF to get SLIGHTLY rich vs. the value of the underlying securities.
When that happens, that's when the AP steps in, and does a creation. They'll sell a big block (say, 50,000 shares, over multiple trades), and then buy the underlying. That will drives the price of the ETF down, and the price of the stocks up.
But yeah, as the individual investor, you don't have to worry much, other than to know it's going on in the background. Now...
If you're an institution - and you're personally trading 50K shares - then you care more.
Because you can call the AP and have them do the trade for you, effectively accessing the creation/redemption window, and getting a negotiated price very close to NAV.
But that's at the giant level.

 

John S: Hi Dave. To follow up on your last webinar comment about dollar-cost averaging ... how do small robo advisors implement diversified ETF portfolios for clients without requiring account minimums? I'm thinking companies like Acorn...
Dave Nadig: Super good question! So, there are a few things that can happen.
The first is that the robo actually just has one pool of, say, SPY. So they effectively run their own "fund" of SPY shares. And they can keep track of which shares belong to who, even if they are fractional.
That's the same solution that different approaches to the 401(k) market have tried, effectively re-skinning the ETF to be able to slice them smaller.
There's always a tail end -- a half share not owned or a half share too much -- but over thousands or millions of customers, it's not impactful.

 

P. Northfield: Why does GOEX have such a high yield?
Dave Nadig: Super narrow question, which I have to partially guess at. So, GOEX is the gold wildcatters fund, if I recall.
Yeah, it's the Global X Gold Explorers ETF.
So the nature of that business is that you either boom or bust. The underlying firms either make a lot of revenue, or they go out of business.
The challenge here (and I'm just speaking from my basic knowledge of the space, not the specific fund's methodology) is that you could end up with huge yield, but not necessarily huge total returns.
In other words - do you really want a 20% dividend if the NAV just goes down 20%? Probably not.
But this is a case where, because the fund is super heavily concentrated (I'm guessing) in a few names, you could do a little company research to understand what they're distributing, and why.
The narrower the ETF, sadly, the more homework you really have to do.

 

Mark from Ohio: Good afternoon. I am a lazy portfolio investor (3 + REIT) and I need 1 core international ETF for my retirement plan. Please provide some core options. I do not want 3 or 4 internationals in my account. Thank you!
Dave Nadig: I love the honesty.
I'm the world's most boring investor myself.
If you're looking to have a single int'l equity position, chances are what you really need is some verison of "all world minus the U.S."
So that would include every region, emerging markets, developed markets and so on.
The big-dog in that race is Vanguard's VEU, with competition from iShares' IXUS.
You can get fancier (FlexShares has a dividend-focused version, for instance), but these would be a good starting point.
(FYI, you can find these pretty easily with our search tool at etf.com/finder)
But with all these kinds of questions, where you end up with a few big funds, that are clearly diverse, cheap and trade well, I think the question you should always ask is "can I do better?"
It's worth looking at the competition and seeing if, for instance, you see a cheaper fund, or a particular take on the exposure that resonates with your world view, and so on.
But it's not terrible to start with the established winners and ask that question - the answer may in fact be, "nope, there's a reason these folks are the top choices."

 

Anonymous: If Vanguard runs funds ‘at cost,’ where do they get they money to launch new funds? Do fund shareholders of existing Vanguard funds subsidize fund costs of a new fund that can’t cover costs while it’s still small?
Dave Nadig: I think a lot of people misunderstand Vanguard's corporate structure.
There is in fact a corporate entity - the Vanguard Group - and it's not strictly a nonprofit.
There are no rules that say, "the company cannot accumulate cash." So the management of Vanguard essentially decides based on what their strategic objectives are, how much they have in cash, and what their income looks like, how they want to fund growth.
It's a "nonprofit" in the sense that the motive is different, and there are no third-party shareholders to return dividends too -- it's all owned by the funds themselves, and thus the shareholders of those funds.
The way "profit" comes back is through lower and lower fees.
But they have a huge cash war chest, still pay their people well, and so on. They can say "we're going to spend $100M on marketing a new thing." They just don't ALSO have to pay dividends to corporate shareholders or do share buybacks and so on.

 

Michael T. Kennedy: Several ETF providers, including Cboe Vest and Innovator, have submitted filings to bring defined outcome ETFs to the marketplace. From what I understand, these are essentially structured notes in an ETF wrapper. A few questions: 1) Do you believe the SEC will approve these products? 2) If so, do you see much demand for them? Will they gain assets?
Dave Nadig: So there are two things going on here. The real issue that NEEDS to be solved is decumulation.
We're really good, as an industry, at teaching people how to save, and at building products to help them grow their assets.
But we're generally terrible at helping people take a $1 million nest egg and then use it.
That's what these "defined outcome" products are (sort of) trying to be part of -- the decumulation solution.
I guess the big issue I have is that we already have these products -- they're called annuities.
The hoops that you need to jump through to produce the defined outcome streams without actually involving a risk-taker (an insurance company) are immense.
So the first runs here are (if I recall) simply collared strategies -- you can't lose more than 5%, you can't gain more than 20%, for instance.
That's totally achievable just through smart options trading.
Do I think there's a real market for it? Honestly, I'm very skeptical.
I think smart advisors put strategies to work for clients like this already, and these don't really address the decumulation problem. They just address the risk-avoidance problem.
OK, one or two more questions here.

 

TickerTrader: One of things I always hear is that you "should check under the hood" of what ETF you buy. But if one uses advisors, isn't that their job to tell me, a client, what is under the hood?
Dave Nadig: I'm a very active trader. Is there something that makes one ETF better for day trading than another? Is there something I should be looking out for?
Well, the sort of obvious answer is simply "tradability" -- we covered this a bit in the webinar. If you're day trading, obviously you care a lot about spreads and volume.
And you care a lot less about annual expense ratio.
One thing I think I'd be cautious of: I've talked to traders who get very ticker blind.
They see "a thing" move and have a certain chart pattern and they get all excited.
An example is things like leveraged products.
I've seen blog posts about chart patterns in leveraged products, and that really makes me scratch my head.
ETFs are derivatively priced. Nobody is "pushing" the price of a 3X S&P fund up or down -- the fund is just responding to what's happening in the S&P 500, which itself is just derivatively priced from the underlying stocks.
So if you want to daytrade something, have at it, but I'd just understand that the drivers are going to be very different than, say, the drivers of a frothy day in your favorite midcap stock.

 

Tina: ETFs seem to have been a large part of the market correction earlier this year. Can they cause a larger issue than MFs?
Dave Nadig: Ooof, well, that's a big question, so I think I'll wrap with this one.
So, first off, ETFs are roughly 1/3 of the value traded on the U.S. exchanges on any big volume day, so it's inconceivable that ETFs won't be part of the story when the market goes up or down a few percent in a hurry.
But it's worth asking two questions:
1) Is there anything in the ETF structure itself that contributed to whatever event?
2) Did ETFs function as designed during whatever event?
The second question has pretty much been always been a resounding yes. We've had a few trading events where we've had anomalous prices, but those were really market structure issues, not ETF issues.
On the first question, I guess I remain unconvinced. Even going back to the 2010 "flash crash," it's clear to me that ETFs got wagged, not the other way around.
I don't mean to sound like an apologist - but ETFs are just another place investors can express opinions. They happen to be very liquid and efficient at it.
So if (for example) everyone wants out of muni bonds NOW, well, the ETF will show that very fast.
20 years ago, there was no fast way for the market to express that opinion.
So ETFs have compressed time, really.
As for mutual funds? The bigger issue to me is how they get hurt in a crisis. Witness Third Avenue mutual funds shuttering its junk bond funds.
The ETF structures basically rode that era out perfectly, but TAMF investors got really hurt, because they had no clean creation/redemption outlet to unload securities and thus be part of price discovery.

OK folks, that's going to wrap it for today. As always, a transcript will be up shortly. Also we'll have a replay of our ETF 101 webinar up in the next few days as well.

We'll do this again, same time next week (the Live Chat, not the webinar)!

Have a great afternoon.

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