Live Chat: ETFs, Direct Indexing & Jargon

April 25, 2019

[Editor's note: Join us for a weekly Live Chat! with Managing Director Dave Nadig.] 



Dave Nadig: Good afternoon, and welcome to Live!
As always, you can ask questions in the window at the bottom, and I'll get to as many as I can in the next 30 minutes.
Let's roll ...

Alice: Soundtrack?
Dave Nadig: In honor of Mayor Pete, I'm listening to his favorite album: Hail to the Thief by Radiohead:

Rookie: I realize you can't get to all questions, but could you address my question from last week about the difference between ETFs and direct indexing? Thank you.
Rachel Weissmann: Good morning Dave. What exactly is “direct” indexing? How does it differ from the indexes that ETFs are based on?
Dave Nadig: Double whammy here; I guess folks are interested!
So, in direct indexing, instead of buying a mutual fund or ETF which then in turn owns, say, the 500 stocks in the S&P 500 ...
... you instead simply have your broker buy all the stocks individually. If that sounds like a nightmare, it doesn't have to be.
Firms like Parametric and Optimal will do this for you, and even let you own fractional shares. Theoretically, you could follow any index this way.
So why would you bother, when you can get an ETF for under 10 bps? Customization, primarily.
Direct ownership lets you do things like tax loss harvesting at the single-security level (selling Merck because you can book the loss, and replace it with some Pfizer, for instance).
It also lets you tweak if you have specific needs. Let's say you work at Apple, maybe you'd like the S&P 500 - AAPL.
Or you want to avoid fossil fuel companies. Easy to do with a direct index approach.
Software makes all this pretty trivial, and you'll see more firms offering versions of this (Wealthfront does now) to lower and lower account sizes.
Right now, you generally need $100K or more to play.
And generally, only equities.
But that will all change.

Etienne: What’s a “bump zone”?
Dave Nadig: So, I'm guessing what you're referring to is the cap gains bump zone.
Usually what people mean by this is when you end up with cap gains that push you up a tax bracket.
In the worst case, you can end up with some pretty complex situations. I think Michael Kitces wrote a piece on this ... one sec.
That's a great piece that gets deep in the weeds on this.

T. Turnblad: Who are some investing/finance “gurus” you respect or follow (past and present)?
Dave Nadig: Good question! So, my answers are mostly pretty boring.
Ben Graham (The intelligent investor), Burton Malkiel (Random Walk), John Bogle, etc.
Outside the mainstream, I'm a pretty obvious fan of the work that Ritholtz Wealth Management does every day demystifying the markets.
The whole crew there: Barry, Josh, Ben, etc.

Pink Pony: How does ETF lending work per the Bank of Japan announcement?
Dave Nadig: So, the headline was that BoJ, which owns a TON of the Japanese equity market, would start making its shares available to borrow.
I think they haven't really clarified what that means, functionally, but I assume it means they would loan shares out just like you loan shares out in the U.S. -- so that short sellers have a locate in order to short.
This adds some liquidity to the market and is incredibly common in most markets.
Most lending happens at the single-stock level, but hot sectors (cannabis, etc.) often have strong short demand as well, as people try and "call the top" in trends.
I don't think this will have any huge impact here though.

Avery: Some investors are concerned with the ETF structure during times of extreme market stress (especially for newly launched ETFs with lower asset levels). What comfort can you offer as it relates to price vs. value variations during massive sell-off periods? Thank you.
Dave Nadig: So, this is a pretty common hand-wringing bit of fear/uncertainty/denial from anti-ETF folks.
The reality is we've been through some incredible market stresses where ETFs have performed perfectly. The last time we had a hiccup was really 2010, and that prompted some small changes in how stocks and ETFs are halted and reopened.
In the narrowest markets, like junk bonds, the ETFs actually act as the "real" market when you get stress.
"Stress" in bonds tends to mean nothing changes hands. Bonds lock up. But the ETF will generally trade a ton -- so the "right" price is the one the ETF is trading at.
Not some hypothetical price a nontrading junk bond "should" be at.
So in short: The arbitrage mechanism continues to keep ETFs trading in line, even when we've had some rather dramatic price moves.
Even in 2008/2009, ETFs did what they said on the tin.

ETF Bro: What percentage of fixed income ETFs create/redeem in cash? I get why it's done for loan or high yield ETFs but are there any positives to creating/redeeming fixed income ETFs?
Dave Nadig: So a lot of bond ETFs do creations/redemptions in cash, but its hard to get a precise percentage because it literally changes every single day.
Some firms like PIMCO are pretty notoriously cash only, but firms like BlackRock can do cash one day, and in-kind the next.
Or even cash for creates, in-kind redemptions.
As to why bother? It's usually a judgment call on the part of the portfolio manager about what they think the most efficient thing is. If they believe they can take cash and get better prices, quickly, they'll do that.

Steffen: Hi Dave. What are your thoughts on the Stoxx - Axioma merger?
Dave Nadig: So the headline here is Deutsche Borse, the exchange, which owns Stoxx, the index provider, bought Axioma, and is mashing them together.
Axioma is primarily an analytics engine.
So when you stick the two together, you end up with a company that looks a bit like a mini-MSCI.
MSCI, after all, is in precisely those two main businesses as well.
So it's a model that clearly works. That said, I'll be curious whether you see Axioma-branded indexes start to come to the front.
They've collaborated in the past. I think they have some Stoxx factor-based indexes already.
So it seems quite logical given the margin pressures in the index space.

Dustin: What say you to detractors who call ETFs a craze or an obsession?
Dave Nadig: Well, it's been 25 years or so, so this is hardly like TikTok or Fortnite!
ETFs are just a more evolved version of wrappered investing -- it's a better mutual fund than a mutual fund for most (not all) use cases.
So as money comes out of mutual funds naturally (profit taking, panic selling, minimum distributions, inheritance, whatever ...) it's entirely logical that the money ends up in ETFs eventually.
I think direct indexing is the next one in line. It will do to ETFs what ETFs have done to mutual funds. But just not right away; like a decade from now.

Todd Rosenbluth - CFRA Research: Hi Dave. What piece of ETF jargon do you wish the industry would stop using to make it easier for more novice investors to understand us ETF nerds?
Dave Nadig: Beta, smart beta, strategic beta, alpha.
These are "assumed" to be understood. Most investors I talk to really have no idea what they really, truly mean.
Now, I don't have a BETTER word for the concepts they represent, so it's a bit of a cheap shot. But I think this is something we all don't do a good enough job explaining.
ESG is similar - nobody can even agree on what it means.

J. Rose: Hello Dave, How have MLPs been doing lately?
Dave Nadig: Short answer: Pretty much in line with the market last time I looked.
Long answer: I haven't even begun to really think through how the various MLP structures have played out in terms of people's actual 2018 filed taxes.
Tax and structure are incredibly important for MLP investing.
Here's our core article on the topic:
We had an RIA interview a while back going through some of the details. One sec.
It's worth noting that while "marketlike" so far this year, MLPs as a total return vehicle are tough if you look, say, over the past five years.
So it really comes down to the tax/distribution advantages, which requires a substantial amount of homework to match the right fund with your very specific tax situation.

Jerry: Hey Dave, Today I read an article that said some ETFs have “collapsible payouts”; what is that?
Dave Nadig: I'll be honest, I've been in this business for a long time, and I have never even heard this term before.
I could pretend and go Google it, but where would the fun in that be? I'll go do that after this chat (as will you I'm sure!) but I'm going to GUESS it has something to do with how dividends are distributed.
OK, last question for the day:

Esme Gonzalez: When I consider what potential asset classes I might want ETF exposure to, I’m wondering what makes an entire asset class go up or down; because it seems like things happen to specific companies, not asset classes as a whole. Thoughts?
Dave Nadig: This is actually a really good question.
So, broadly speaking, macroeconomic factors tend to make whole kinds of investments more or less attractive.
So let's take a simple example: Iran decides to try and block the Strait of Hormuz.
That's a big, macro, exogenous event.
The impacts initially are pretty simple: less oil moving out of the gulf, oil prices would go up.
But then investors and traders will immediately try and assess "who wins/who loses."
So you might see a whole range of companies immediately trade higher and lower based on their exposure to the price of oil.
For instance, you could see airline stocks all get hit -- the price of petroleum is a big cost for them.
If you pull even further back, to something like interest rates:
Let's say the return of the 10-year bond goes up 1% ... well, now those bonds, which are risk free, are more attractive, so investors will take their money from other assets to buy bonds.
So you'd expect equities -- the whole asset class -- to trade down.
This is why the Fed is in the news every day.
Every asset class tends to have these big externalities that can push prices of all the securities in the asset class around.
And from THAT baseline, things like individual earnings will move the prices of companies around.

OK, that's it for me today. Thanks for the great questions as always, and we'll see you next week!

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