Live Chat: Arnott's Next Phase & Defined Outcome ETFs

August 09, 2018

[Editor's note: Live Chat! with Managing Director Dave Nadig happens Thursdays at 3:00 p.m. ET.]


Dave Nadig: Howdy folks, welcome to Live!
Sorry we took a few weeks off, but we're back for the foreseeable future.
As always, you can enter questions in the box below, and I'll answer as many as I can. We'll post a full transcript later on this afternoon. With that, let's get started.


James F.: Thoughts on Arnott "stepping down"? Seems like an icon.
Dave Nadig: So, background: Rob Arnott has handed the CEO reigns over to Katrina Sherrerd.
I'll be honest, I thought this had already happened -- Rob is staying on as chairman, from what I've seen, and I see this as a "soft retirement" more than anything.
RAFI is in Rob's blood. I can't imagine a world where he would actually step away completely.
It's also worth noting he has just a dream team of high-quality talent there.
So if I were a RAFI customer, either directly or through things like the RAFI funds from PowerShares, I wouldn't be worried that there was some sort of brain drain imminent.
But yes: an Icon for sure.


Nemo: The defined outcome ETFs just launched the first 2 of 12 yesterday. Most of the other ETFs are just different quarterly tranches. Is there any reason they did not choose to launch a fund-of-funds that automatically rolls new investments into the appropriate quarter throughout the year?
Dave Nadig: So, really good question, and I don't have a specific answer from the inside of the equation.
However, I will say in general the options positions here make management a pretty precise thing.
Also, there'd be tax implications in the fund-of-funds structure (I believe).
On that, if a fund owns another ETF, and then sells that position to buy another for a profit, that's a gain for the shareholders.
Of course, rolling an internal position is also a gain, but I think the way they've done it gives them a bit more control.
Side note (and pre-answering a question I see below) -- I think these products serve a real niche demand.
A whole passel of advisors has built practices on using options in a smart way to manage risk; these things really just package that up.
I worry a bit investors will shy away from them because they have options under the hood, which could make them seem "scary" -- when in fact, risk control is the whole point.


Tim Lincoln: So why were commodities not a poster child for a decade, and why are they coming back?
Dave Nadig: I'd love to say I think there's a good, investment-thesis-related answer, but I honestly think it's just performance chasing.
Whether it's gold or oil, investors have really jumped in when commodities have seemed to have real momentum.
Take oil for instance.
Pull up a chart of USO, and you can see that while it's had a bit of a rebound, it's still just an awful chart.
Compare that to, say, what happened 07-08 -- we're not even in the ballpark.
So why will they come back now? Well, a bit of momentum, but I think it's going to be pretty targeted and tariff dependent.
Take soybeans -- the tariffs are hitting during a non-harvest period, so the "prices" we're seeing deflated aren't real prices.
Now if they hold out for a year - that's real pain.
But I think we're in a bit of a holding pattern to see how commodities/tariffs interact the rest of this year.


Therese: Hi Dave. What's the magic thing about September per se that is having the SEC wait til then to decide about all the submitted bitcoin ETFs from issuers?
Dave Nadig: The SEC is NOTORIOUSLY fickle about dates. While there are various deadlines written down (we'll give an opinion 60 days after this, etc.) they are all essentially movable at whim.
So I would take even September with a grain of salt. These cans have a way of being kicked down the road.
In general though, the SEC likes to wait 60-90 days everytime ANYTHING changes on any of these topics, to provide room for commentary.
I know the SEC has a page up now soliciting public opinion on bitcoin ETFs (don't have the link handy).


J. Tanner: Is there any difference between ESG, impact investing and socially responsible funds, or is this one umbrella?
Dave Nadig: Boy there should be -- they tend to get all lumped together under the "ESG" umbrella, but frankly, that's a mistake.
It's a bit like saying "anything that's not cap weighted is smart beta" -- it's not neccesarily wrong, but it's not neccesarily right either.
Impact Investing has a pretty clear definition -- you're investing in companies that are making a positive change in the world based on some sort of criteria you may have.
So for instance - just avoiding gun stocks isn't Impact Investing. Investing in a company that does microfinance to women in Africa? Impact Investing.
SRI I tend to use for approaches that are literally following the UN Socially Responsible Investing paradigm, which is a quite specific set of guidelines.
And then there's just a whole raft of "issues-based" or even "faith-based" approaches that are really all unique.
So it's a pretty personal definitional issue, especially since many times the investor is looking to meet a non-economic need.


Robert Ferman: Hello Dave. Do you see robo advisors utlimately replacing human advisors?
Dave Nadig: Hi Robert, GREAT question.
So, for a certain class of investor, who would otherwise buy a DIY Schwab customer, for instance, I think robos can be a great uptick in their asset allocation sophistication.
But most financial advisors haven't built practices on 100K accounts with a few positions, they've built them on much larger and more complex situations.
So there's this narrow band for folks where a robo might be ALL they need, and then there's another band where you might need a human once in a while, but your asset allocation/rebalance work is all handled through a white-label robo approach.
Just today I saw an article about how Betterment was trying to do MORE face-to-face work with customers, not less.
So I think the pendulum is swinging more toward "bionic" approaches, which, incidentally, is the way it works for Vanguard, and the way it works in all of Canada.


Guest: Hi Dave. Writing from Canada here, so naturally my question is surrounding active ETFs - they are expensive, non-transparent, and encourage regular trading (possibly the worst thing you can do to a portfolio). Yet they are popular, and only getting more so. What gives?
Dave Nadig: Speaking of Canada...
Last I looked, active ETFs in Canada were about 15% of the market, and 1-2% of the U.S. market.
We've seen some product launch here, but not a lot of assets.
If you remove PIMCO and DoubleLine total return products, it's a tiny number.
There ARE some products that are doing well (both assets and performance) -- ARK and Davis come to mind there.
But the flows really haven't blown the doors off. And ultimately I think it will be a slow trickle.
The most important impact, however, is what's going on in fees. While 60 basis points for an ETF all-in might seem super expensive, it's actually very cheap for traditional active.
So the fee war is coming to active in a big way, and ultimately that's all good for investors.


Heidi Feingold: HI there Dave, I've been wondering how ETF issuers can survive if they all do eventually get to zero fees?
Dave Nadig: Hi Heidi,
So, I don't think ALL fees go to zero.
I think we'll see a handful of core-beta-type products go to zero, but not, for instance, junk bond funds, or smart-beta funds.
at least, not in the next 10 years.
But even assuming that, it IS a real issue for companies that don't own a client relationship -- like, say BlackRock.
Nobody owns IVV directly from BlackRock; they own it in their Fidelity or TD account.
Fidelity and TD can make money in all sorts of other ways -- account fees, selling insurance, you name it.
So it wasn't surprising to see Fidelity being the first one to go to zero -- they have so many other products -- and expensive funds -- to subsidize the cheap beta.
I also think you'll see more unbundling -- even in things like 401(k)s, where you get explicit charges for things like recordkeeping.
I'm actually all for that -- charge where the expense is. And the reality is, an incremental dollar in U.S. large-cap is effectively free to run for a large index ETF.
OK, a few fun ones and then back to the hard-core ones:


Not an ETF Question: I know from Twitter you are a gamer -- what's your videogame-of-choice?
Dave Nadig: Well, there's a new World of Warcraft expansion dropping this weekend. But most often, I play a team game called "League of Legends" -- thanks for asking!


C Tompkin: Would you consider putting a themed crossword puzzle in ETF Report? I miss doing that from your Journal of Indexes.
Dave Nadig: We quite literally just discussed this on an editorial call today. We're considering it! I'd suspect we'll do one once in a while, but not every month in 2019.
OK, back to the meaty stuff:



Nate Geraci: Also, thoughts on what happens once Vanguard patent expires from a competitive landscape perspective?
Dave Nadig: Hi Nate (and don't forget to check out for the weekly podcast we do with this fine crew!
So, there are, if I recall, SIX patents that touch on their ETF business.
There are two I have bookmarked that are the meaty bits:
7,337,138 and 6,879,964
The first is an amendment of the second.
And they were filed in 2005 and 2001, respectively.
Utility patents have a life of 20 years.
So, depending on how you count, the patents START expiring in 2021, and will be essentially done in 2025.
That said, once the patents START expiring, I wouldn't be surprised for someone to challenge them and/or license them on the cheap.
The patents really HAVE been a defensive barrier for traditional fund companies.
But I think we're still a few years off before that changes ... and in the meantime, folks like Fidelity aren't sitting still.
So, much like the ETF Rule, I think when the patents finally go away, it just won't matter THAT much, because so many folks will already be in the pool!


John Hancock: Dave: A number of ETF providers contain a mix of equity, bond and commodities within the ETF. Though the bonds often pay distributions monthly, shareholders may only receive distributions quarterly similar to the equity portion. Do providers like Cambria and iShares improve the yield any by passing along additional interest on the bonds for the months leading up to the quarterly distributions?
Dave Nadig: This is actually a broader issue -- companies pay dividends all the time, but most ETFs only make quarterlym or at bestm monthly distributions.
So yes, the common practice in any portfolio management process is to stay fully invested.
So if you get a coupon payment worth $1 million, the fund manager should, all else equal, go buy a tiny slice of EVERYTHING in the portfolio to stay fully invested.
In actual practice, these kinds of small cash distributions are run through an optimization process.
ETFs, in fact, were originally invented in part to solve this "equitizing cash" problem for big institutions.
You can't buy everything in the S&P 500 efficiently with $1,000. But you can buy 4 shares of SPY.
There is one HUGE notable exception to all this and that is in fact SPY -- because it's a unit investment trust under the hood, it can't, legally, reinvest dividends in ANYTHING
So there's always a few basis points of cash drag when the market is going up, or buffer when it's going down.


Sidney Halwell: Is planning on doing anything other than webinars for CE credits? Thanks.
Dave Nadig: We are looking into this -- we used to offer CE credits to subsIt's like cribers of the Journal of Indexes when we published that. We're considering a way to make it available for our core education articles as well. Stay tuned!.


Archie: Good morning! How does one get invited to Camp Kotok? :)
Dave Nadig: You'd have to talk to David Kotok! It's entirely at his whim. I've been very honored to be on the invite list these last few years. Hopefully the recap articles have been a good glimpse of the discussions.
OK, one or two more here:


Alex L.: What are some great ideas for ETFs (in your opinion) that never really got off the ground?
Dave Nadig: Well, target-date funds are in fact a great solution for a lot of smaller investors, but they just didn't make all that much sense in an ETF wrapper.
They're nearly dominant in 401(k) plans, and make sense for dollar cost averaging -- two areas in which ETFs are often a mediocre fit.
So, not surprised they didn't work well in an ETF wrapper.
I think we've seen some thematic ETFs come and go a bit too quickly too -- MENU and BITE, for instance, solid approaches to a real sector -- restaurants.
I'm guessing we'll see those again.
OK, that's a wrap for today.
As I mentioned, don't forget to check out the weekly podcast. Here's a link to this week's: ETF Prime Podcast: What's Behind 2nd Fastest Growing ETF?
Thanks everyone, and we'll see you next week, same time, same URL!

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